Naya Investors thank him for his contribution.
What is subprime lending all about?
Subprime lending, also called "B-Paper", "near-prime" or "second chance" lending, is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history (HSBC).
Every adult American should have a “credit score”. This number ranges between 300 and 850 and indicates his or her creditworthiness. This figure is derived from credit reports based on past performance and income levels and is compiled by three major credit bureaus i.e. Experian, Equifax and TransUnion.
When a lending institution extends funds to a person with a credit score of less than 620, the loan is known as a subprime loan. These loans would generally have higher interest rates than prime loans which is the compensation for the higher risk borne.
Given the low interest rate environment and easy availability of credit, mortgage lending institutions in the US had been under pressure to raise revenues and profits. The only way to do this was to lend money to higher risk borrowers at higher rates of interest with the hope (or was it belief?) that repayments would be made in full and on time.
To entice subprime borrowers, mortgage lenders introduced what is called a 2/28 ARM (adjustable rate mortgage). This involves low teaser rates for the first two years and then a floating rate based on an industry index like the 1 year CMT or 6 month Libor. Rates would rise sharply after the reset and then fluctuate with the market. Subprime borrowers usually take these 2/28 loans and then try to improve their credit ratings or scores so that they can refinance their mortgages before the floating rates kick in.
How did simple mortgages end up causing a worldwide financial crisis?
To answer this question it is worthwhile to follow the subprime money trail through the financial system. Diagram courtesy HSBC.
The Money Trail
- A subprime borrower takes a mortgage from a mortgage institution like Wells Fargo Home Mortgage at the 2/28 ARM terms.
- The mortgage institution or lender pools together many such mortgages and sells these onwards to financial institutions like banks.
- The banks then proceed to securitize these loans, chop them up, and package them into products called CDOs or Collateralised Debt Obligations which entitle the holders to the cash flows from the underlying mortgages.
- These CDOs are then sold to other market participants like hedge funds, pension funds, other banks and insurance companies based all over the world.
- The CDOs may then be traded like any financial security and thus ended up being held by banks and other market participants all over the world.
From mortgage to crisis – how did this happen?
When investment banks started packaging the loans into CDOs, they put together tranches composed of varying proportions of prime, medium prime and subprime loans to get a desired rating for each instrument.
As these were credit products the banks needed rating agencies like S&P, Moodies, Fitch etc to rate their credit worthiness. Unfortunately the credit rating firms followed an average risk approach to rate these CDOs.
The prime loan portions of the CDOs led the rating firms to bestow their highest possible ratings i.e. “AAA” on most of these instruments. AAA rated instruments imply the highest level of security or lowest risk. This indicates to possible investors that the there is very little risk of default.
The basic principle of finance states that higher the risk, higher the expected return. Yet these CDOs were rated almost completely risk free but were offering returns that were typical of junk rated bonds or firms.
Should the market in general have questioned this paradox earlier? One would expect so but in the atmosphere of “irrational exuberance” that was prevailing in the credit markets nobody did. Most participants were taken in by junk yields being offered on AAA rated instruments. Greed, it appears is the lowest common denominator.
One must keep in mind the prevailing low interest rate environment in North America and Europe in the last couple of years. Stock markets too have not exactly been delivering outstanding returns. Banks and other financial instruments were under significant pressure to boost profits and return on investment. CDOs, in these circumstances seemed too good to resist.
The tide began to turn in late 2006 and early 2007. Large numbers of subprime mortgage foreclosures started being seen. Investment banks holding the CDOs tried to sell them back to the mortgage lenders under so called “repurchase agreements”. Some like New Century Financial Corporation were forced to shut down. Hedge funds too started facing redemption pressures. The defaults started forcing market players to liquidate their holdings.
Widespread panic and lack of confidence led most market players to stop lending to each other. Most investment banks and hedge funds had to write down the value of their holdings or liquidate other investments to meet redemptions. With CDO prices at rock bottom levels, market players were forced to borrow heavily.
Most market participants at this time were not aware of how much of the subprime CDOs other participants were holding. Faced with this uncertainty, most refused to lend funds in the overnight money markets to hedge funds or banks no matter what interest rates were being offered.
This led to a huge liquidity crunch in the global markets and subsequently runs on and the collapse of a few banks in Europe. With nobody ready to lend money, overnight rates in the money markets skyrocketed setting the stage for further runs on banks and even the freezing or possible collapse of the entire banking system.
And thats how the cookie crumbles!!
