[#permalink]
07 Dec 2007, 12:48
I'll have a go at it.
So a subprime mortgage is generally a euphemism for a mortgage given to someone with bad credit.
In recent years, due primarily to historically low interest rates, the creation of new derivative instruments that were thought to flatten risk from risky debts, and the profligacy of the American consumer (okay, maybe this last part is a little editorializing on my part), mortgage lending has reached nutty levels. Instances of people who earn $40K/year getting mortgages for 99% of a $750K house reached unprecedented levels.
Anyone with half a brain can see the risk inherent in such a financial strategery (except maybe the type who use the word strategery non-facetiously). As interest rates rose due to inflationary and other pressures, people with floating mortgage rates, or the dreaded ARMs, suddenly started to not be able to pay their mortgages. This itself is a bad situation, but it gets worse.
As alluded to before, these risky mortgages and other debts in recent years have been sliced up, spruced up and packaged up into all sorts of derivative financial instruments (e.g. collateralized debt obligations) by banks and then bought/sold like any financial instrument. The objective was to spread out the risk so that the negative effects of a default by the homeowner wouldn't be so focused and drastic. The problem, however, was that people went way overboard with these instruments, in multiple ways. Some banks/funds simply over-exposed themselves. But probably the most worrisome aspect is that, after all is said and done, no one really knew the value of the assets they were holding or the risk associated with them. They had been packaged so well (and maybe randomly) that it became impossible to value them, and when the Cosby kids hit the fan, well, you saw what happens.
Also, in the case of the banks (as opposed to hedge funds), many of them are doubly exposed to CDOs. Not only did they hold these assets long, but they were often wrote the assets. So when the market dries up, they lose the fees for structuring the CDO and take a hit for the CDOs that they own.
A messy situation.