A primer on the Sub Prime crisis

(Ref: Time, August 27, 2007)

Time Magazine recently gave a lucid account of the US sub prime crisis. For generations, U.S. home price appreciation largely tracked inflation. But since 1995, home prices began rising at an unprecedented pace. The boom created a lot of wealth but also created risks that spread far beyond the housing market.

To attract more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrower's qualifications. Many of these loans had low starting interest rates that would rise over time. As long as home values rose and interest rates stayed low, everyone was happy. But once prices flattened or fell and interest rates crept up, sub prime borrowers became vulnerable. They could not sell or refinance their loans because they owed more than what their home was worth.

In recent weeks, the scenario has changed for the worse and defaults by borrowers have increased. In the past, the trouble would end with a borrower in default and a bank foreclosing on the home. But today few banks hold onto mortgages until maturity. Most loans are securitized, ie bundled together and sold as mortgage-backed securities.

The new owners of the mortgages can use them as collateral to issue bonds to finance other deals. Money from thousands of homeowners covers the interest payments on those bonds. To attract investors, the bonds are rated by risk groups, called tranches. The more secure the bond, the lower the payoff for investors. Those who buy the riskiest pool of bonds - the ones backed by the riskiest home mortgages - are promised the highest return.

To further complicate the picture, some firms create structured finance products, called collateralized debt obligations (CDO), from pieces of other mortgage securities. These new bonds are re-rated, creating an illusion of safety even though the top-rated bonds may include very risky original loans. Last year nearly $500 billion in CDOs flooded the market. Many hedge funds invested heavily in them, often using borrowed money, and thus increasing their exposure.

In short, the entire process is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities) to borrow yet more money (CDOs), and hoping the payment chain does not break. Once home-mortgage defaults started, the whole system began to unravel. Without the payments from homeowners, the issuers could not pay off the bonds. The bonds lost value, and the hedge funds that borrowed money to buy the bonds had to put up more collateral. Alternatively they had to try to sell the bonds, which caused their value to drop even more. The rout began. Banks tightened credit, raising the cost of financing corporate and private-equity deals. Other investors then wanted to reduce their risk. Stock prices fell, and bond prices rose. With global markets so closely linked, fear began to spread rapidly around the globe. Tighter credit meant fewer people getting home mortgages, further depressing the housing market and perpetuating the cycle.