Sub-prime
Think: Why is housing so expensive?
I often go training and what I notice is that people's bags are always stuffed full with gear. And when they buy a bigger bag, they stuff that one full too. It's completely normal, or so we think.
In the past, men worked, women stayed home. What this meant was that the man's single income had to be enough to buy a house. Naturally, this placed a limit on the price of housing, otherwise, no one would be able to afford it. As women entered the job market the 'family entity' had more disposable income so they could afford to buy bigger homes. So you would think. The first buyers would get the bigger homes but later ones would find that cheaper home prices were increasing to meet the new supply of money. So, the harder we work, the more income we get, the more expensive the cheapest homes become. The price of the home increases to meet the money supply in the same way you stuff that bigger bag full of junk. As homes begin to be priced just beyond our reach so the banks in turn begin to lend us ever more money - thus in the end, the price of our home is determined not by what we earn but by what the banks are prepared to lend us. And one way to lend us even more is to lower interest rates. As interest rates get lower and lower more and more people think they can afford ever more expensive homes.
This is all fine until someone loses their job and can't pay the mortgage. If it is just one person, no matter, but if it happens to many at the same time it becomes a problem for those who lent the money, or rather, to those to whom the banks sold on the mortgages in job lots. What? The bank doesn't hold my mortgage?
Sub-prime refers to mortgages that are considered 'less than desired'. Banks lent money to people who they knew could not afford it and labelled it as 'sub-prime', or more honestly, a risky prospect. Why would they do that? In the past it was in the bank or mortgage lender's interest to scrutinize a borrower very carefully lest he not be able to pay it back. However, banks became more like real estate agents who would take a fee for selling a home and then pass on the mortgage to another entity - enter Fannie and May. So, banks and mortgage lenders became more concerned with getting the sale and the subsequent fee than in scrutinizing the client. After all, if they failed to repay, the bank had already gotten its fee and couldn't have cared less - enter the Moral Hazard. In the end they were selling mortgages to people who did not earn enough and even to those without jobs and no income at all. After all, they all 'imagined' that increasing house prices provided future 'income'.
Investors liked housing securites as they seem like a sure-fire bet and the market was hungry for more, but not enough were available - the repackaged sub-prime securities ranging from AAA - BB were snapped up as fast as they were put on offer. While investors knew some would be unable to pay, no one imagined how bad it would get in the blink of an eye. In 2000, the total amount of money in the world was $36 trillion and by 2008 it had grown to $70 trillion. This is staggering rapid growth considering the fact that it took the entire history of the earth to grow to $36 trillion. Such was the extent of the boom.
The crash happened when the number of people failing to repay their mortgages reached tipping point. In most cases, the security for the loan was basically just the house itself, and what with so many houses entering the market at the same time, house prices collapsed. Indicative of how serious the problem is, there is a video on You-Tube of a crane demolishing brand new houses in a vain attempt to reduce supply. Instead of bailing out investment banks, it would have been wiser to repackage mortgages with lower rates, delaying repossession, and to have let people stay in the homes longer - at least the supply of empty homes on the market would have been reduced at that critical time.
Dr Patrick Dixon (an investor, You-Tube) explains how bankers and investors do not understand their own businesses properly. He asserts that they need to be able to look at their balance sheets and know where they stand, instantly. Security products have become too complicated and no one knows where they stand which means at any given time they are unsure of their level of exposure to risk.
As of late 2009, we now have the new concept of 'underwater mortgage'. This is the situation where a homeowner has the ability to repay but finds himself in the unenviable position of owing more than the house is actually worth due to rapid depreciation. Many will just walk away; they may lose out in terms of their credit status, but hell, I think getting new credit would be the last thing on their mind in the current environment. The banks may chase him but most likely he will not be able to pay. Indeed, in ten US States the banks are not even allowed to chase you after you default on a mortgage.
To understand Sub-prime, click on the Derivatives section.