Without a doubt, the subprime lending fiasco has been one of the largest market events of the decade. However, I found myself hard pressed to give a brief, easy to understand explanation of the issue when asked about it. So, I put together a quick primer for our readers below.
Subprime Mortgages
Subprime mortgages are essentially “high risk” home loans made to individuals with questionable credit. Since they carry more risk, the interest rate paid on these loans is higher than a typical mortgage. Traditionally, a bank takes on the risk of these types of loans, and suffers the loss if the borrower defaults on payments. Therefore, the bank has incentive to carefully check credit history and weigh the higher return on the loan against the higher risk of default.
Mortgage-Backed Securities (MBSs)
Now, let’s say that the bank needs additional cash today to make even more loans. They have a portfolio of subprime home loans that generates high returns, but those won’t be paid off for 30 years. Because the payments on these loans are cash flows, they can sell them to other investors and receive money in exchange today for them. So, they sell “mortgage-backed securities” to buyers which represent ownership of those future loan payments.
Realizing that this is a pretty good deal, the bank continues to create and sell MBSs. However, since they no longer hold the underlying loans they don’t have as much incentive to carefully check borrower credit. As a result, they start making loans to everyone with a pulse, and end up “dressing up” these loans as regular subprime loans. In reality, these new loans are much riskier.
High-Risk Subprime Loans are “Dressed Up” and Sold
Collateralized Debt Obligations (CDOs)
Being the savvy finance folks they are, private banks which purchase these MBSs come up with a good idea. They can take these loans and lump them together with other loans and create another fancy pants type of security. They sell these securities as Collateralized Debt Obligations (CDOs). A CDO is simply a portfolio of debt that has been sliced into several pieces called “tranches” which pay various rates of return. Each tranche is sold as a separate security and is paid in a specific order.
Why does that matter? Since the pool of debt is “iffy”, it is less risky to have the first claim on loan payments that do come in. On the other hand, owners of the bottom tranche are last in line, but they also get a higher return for taking this risk
Hedge funds chasing higher returns typically purchase the riskier tranches of the CDO (often dubbed the “Equity” tranche), as they can make above average returns doing so. To further complicate things, ratings companies such as Moody’s put their “AAA” stamp of approval on the topmost tranches, leading investors to believe these are completely safe. This whole operation would probably be fine if the loans underlying all of this weren’t as risky as brushing your teeth with toxic waste.
MBSs are Repackaged and Sold in CDOs
The Fallout
So, what happened? In a nutshell, because lenders engaged in loose lending practices (loaned to anyone) the rate of default on mortgages was much higher than expected. Since these loans represent the underlying value of both the MBSs and the CDOs, these two securities fall rapidly in value. Hedge funds which have borrowed money to invest get margin calls from their lenders and have to liquidate assets to cover their investments. This drags the entire market into the gutter.
Further, since the process of repackaging MBSs is complicated, the banks aren’t sure who will be left “holding the bag” when it comes to losses. Is it the bank’s fault that sold the MBS? The rating company for putting “AAA” ratings on risky debt? As a result, it becomes essentially impossible to buy or sell CDOs, and ultimately leads to the Federal Reserve having to intervene to restore order in the market.