Friday, July 27, 2007

What is Subprime Credit Anyway

A large part of the news impacting the stock market at this time is related to the subprime debt market. Many investors are confused as to what the subprime market is. The Financial Times recently published an interview that defined this market. Following is an excerpt from the interview:
...Very simply, investors over the last few years have been looking for places to put money to work. Corporates haven’t been borrowing, and even governments have enjoyed improving budget balances and have had to borrow less. Forced to find a place to put their money to work, investors began to look to subprime borrowers - the individuals with either low income or bad credit or both - as a potential investment option. Banks would provide the cash for mortgage loans to subprime borrowers, and then they would bundle those loans up into one big package, sometimes called a pool, and then sell securities whose value was linked to the performance of the pool of mortgages. Investors could buy the securities and were effectively lending money to the subprime borrowers, with the banks serving as the middlemen.

The collapse has been due to something very simple: people lent money to borrowers who couldn’t pay it back. Now the process is beginning to snowball; subprime borrowers are defaulting, which puts homes on the market for a forced sale, which drags prices down, which makes it more difficult for other subprime borrowers to refinance their mortgages into loans with better terms, which then causes more defaults.
Barry Ritholtz, the Chief Market Strategist for Ritholtz Research, maintains a web blog, The Big Picture. He recently posted a graphic that diagrams the various subprime pieces and how they are created.

Turmoil in the Credit Markets
Financial Times
July 19, 2007

Cool! Residential Mortgage Backed Securitization Process
The Big Picture
By: Barry Ritholtz
July 27, 2007

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