What is subprime lending
The term subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status.
In general, subprime lending (also known as B-paper, near-prime, non-prime, or second chance lending) is lending at a higher rate than the prime rate.
However, in U.S. mortgage lending specifically, the term “subprime” simply refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.
How the Subprime Mortgage Problem Developed
The problem now challenging financial markets and the economy stems from historically low interest rates that encouraged millions of Americans to refinance their fixed rate mortgages. The lower interest rates meant that buyers could afford larger mortgages. Effectively, a bidding war broke out that raised the prices of homes. While some markets had larger price appreciation than others, higher prices limited the number of potential buyers. In response, the home financing industry developed new products that allowed otherwise unqualified individuals (by income, assets, and/or credit history) to receive loans to buy or refinance a house.
These same products also allowed creditworthy households to buy more expensive houses or to refinance their current houses to obtain cash for other uses. These riskier mortgage instruments, referred to as “subprime” loans, in recent years have come to account for an ever larger share of the mortgage finance market.
The hedge fund trade and stock market crisis
The typical subprime mortgage hedge fund trade goes like this:
Borrow at lower rates and invest that money into high interest bearing financial instruments.
1. Borrow in Japan paying 2% interest, then convert to US dollars.
2. Invest US dollars in US CMO (collateralized mortgage obligations) paying 8% (subprime mortgages get higher yields).
If that was all that the hedge funds did they would have lost money, but a credit crisis could have been averted.
To maximize the returns (“the greed”), the fund manager asked for a loan to increase his leverage…like buying on margin. This increased leverage on an already leveraged investment increased the hedge funds yield to over 15%!
But as with all over-leveraged positions, this also carries an inherent risk – the dreaded “margin call”.
The underlying value of the CMOs started dropping as a result of the defaults on the underlying mortgages (picture below). Since the CMO itself was devalued, the hedge fund gets the dreaded “margin call” to cover his positions. The hedge fund manager doesn’t have a Billion dollars sitting idly by so he must look at selling the CMOs themselves to cover his margin…but because everyone is now worried about how deep the defaults go inside the CMO’s, no one is a buyer.
So now the hedge fund manager needing to raise cash fast is forced into selling other stocks, bonds, etc….and the stock market takes a beating.
Mortgage Fraud Rate