subprime mortgages.

subprimes mortgage loans are given to people with poor credit score or basically someone who cannot get a prime mortgage. in that, i just learnt that normal mortgages are called prime mortgages.

the main difference in the mortgage loan itself to the borrower's concerns is that subprimes offer an introductory period during which interests may be low or the payment only covers interest and not the principal. basically, the required monthly payments during the introductory phase is lower than normal. if that's not the main reason why people get subprime loans, it's because they simply cannot get normal prime loan due to bad credit and no approval.

why so many subprime loans given out? because the system largely used brokers who got a commission from selling one of these loans, i.e. getting someone to get the loan. therefore, the incentive for the broker is maximising sales and he is not concerned with whether the borrower actually is trustworthy or has a decent background for a loan et cetera. to get more commission, some - not all probably - may employ cheating tactics. to cheat the borrower, the house in question may be overvalued. to cheat the lenders, information may be bent, twisted, or omitted in order to qualify the borrower for the loan.

problem arises when the borrower is unable to make his or her payments. one, it could be because the introductory period is over and the interest rates jump up. for example, during the 2 year introductory period of a 2/28 (2 year intro, 28 year remaining) mortgage loan, the interest rate may be 1% [number arbitarily chosen by me]. the monthly payment is lower. though i did not check, it makes sense to think that the monthly payment has not been the same and not that the only effect of a lower interest rate is that during the intro period, less money is allocated to the interest payment and more to the principal. after the intro period, the interest rate may jump up to 5% (or perhaps 5.1% if a normal 30 year prime loan would have a 5% interest rate and because of the subprime discounted intro period, the remaining 28 years require a 5.1% interest rate to balance the figures). the fundamental idea is that the payments increase. the borrower cannot repay and defaults. foreclosure occurs. the lending institution now takes the house.

for the borrower, this spells doom because he or she has no house now. but the economy and my academic interest is more concerned with how this affects the market altogether and created the economic crisis. I gather that the main issue now is not just that the lending institutions have a lot of houses, but because the houses are depreciating in value. this happened because of the housing boom following the subprime lending but with it failing, the houses started to be foreclosed and the supply vastly exceeding demand. the lending institution may have gotten some of its loan money back from earlier payments (say 10% until the borrower defaulted) and now claims the house which is however only worth say 60% of the loan. Assuming the house can be sold at that value, the net loss is 30%.

who lent the money. because of the securitization of subprime loans, as it is called when these loans were packaged into an investment vehicle and traded on the market, the money lenders (I believe normal prime loans are also securitized and traded on the market?) turn out to be the regular market trader. the straw through which they lent turn out to be investment corportations such as Merill Lynch and other similar institutions, though not limited to them. With the value of the product, being the house, dropping, it should only follow that the value of the stock is perceived to be lower that what people had imagined it to be. instead of rising, say from $20 a share (or is it stock) to $21 and above (as property was perceived to always appreciate in value), a 60% value of that share would now be $12. Though it may not reflect on the market, confidence drops and people start selling. perhaps that is the power of efficient markets and perfect knowledge, as I somewhat understand it. Selling and selling leads to the stocks losing value. I don't know how, but this causes the company to collapse.

well, apparently the sell of stocks is not directly a cause of the company's failure. a company does not pay when shareholders sell its stocks nor does it earn money when another buys it except for the time when stock is initially issued and sold. the relationship here occurs because the firms involved are investment firms and banks (Merill Lynch, Bear Stearns, Lehman Bros, Washington Mutual...). With them, their existence is dependent on people's confidence and pumping of investments through them. The falling prices of the company's shares signal that something is wrong and confidence drops, decreasing investments and initiating withdrawal of savings and investments from the firm. After all, the former is an investment in the firm itself and the latter investments through the firm into another company.

why did the borrower take the loan when they knew the interest rates would jump after the introductory period. The simple guess is that they needed or wanted a house and the intro rates were easier than going straight for normal rates. Not only that, they may not have been able to get prime mortgage loans because of their credit history. The profile of the borrower is poor and less able to afford housing. Both the borrowers and lendings assumed that the people would become wealthier and would be able to afford the normal interest rates after the intro period. Not all subprime borrowers have defaulted, so subprime lending has worked for some in giving them a home. As for refinancing, it was difficult as the houses had depreciated in value (or they were overvalued in the first place and the loan was too high compared to the real value of the house).

then there are speculators who purchase the house with a loan and low monthly rates with the intent to sell high as the property appreciates in value and covers the initial principal loan, interest paid so far (which is low during the introductory period and therefore appealing for such speculation), the effects of inflations, and the early repayment charges all combined with yet a profit. such speculation widens the gap between the actual demand for the houses and the supply as the housing boom took place.

so the subprime crisis is basically lending to the wrong people (in the sense that they ultimately failed to keep up payments), the devaluation of the houses caused by excess supply and foreclosures (would the problem still happen if the houses were not depreciated but merely vacant and owned by the bank with the value of the house and money received back from the loan so far equal to the principal loan issued? in such a case, the only loss I see is the loss from not getting interest payments from the initial loan. however, if the house continued to appreciate in value as property should have, no net loss would have occured, yes?), and panic and drop in confidence leading to pulling out of investments and savings in and through the financial institutions.

the first reason constitutes a range of factors such as poor rating on the actual risk of the securities, bad regulations perhaps with apparently banks being forced to give subprime loans or be sued, a faulty system of commission for the brokers which led to loans being issued to people who perhaps were very likely to fail to keep up their payments et cetera.