How Subprime Mortgages Can End Up In Your Investments

I came across this article in a local business magazine which sums up nicely how knowingly or unknowingly subprime mortgages can end up in one's investments. I believe you are aware that the current subprime woes have massive sell-down on global financial markets, due to major concern on potential tightening on global liquidity, significant losses on global funds with exposure to subprime and ultimately impact on global economy. The following is the money trail of subprime:

Cycle 1
- Buyers with weak credit background secured housing loan from (subprime) lenders and typically pay annual mortgage rates that are at least 2% points higher than average bank lending rates

Cycle 2
- Mortgage brokers, mostly based in California, collaborate and form partnerships with the once profitable subprime lenders and Wall Street;

Cycle 3
- Subprime lenders attracts people with exotic mortgages without documentation-free loans, which do not require evidence of income or savings.

Cycle 4
- Large Banks / wholesalers buy the subprime loans. They then bundle the debt and sell it to Wall Street firms.

Cycle 5
- Wall Street banks package subprime loans into mortgage-backed securities and collaterised debt obligations (CDO). Sales of CDOs reached USD2.4trillion in 2006!

Cycle 6
- When a bank creates a CDO, it meets with credit raters to discuss the quality of the contents, including subprime debt. They then divide the CDO into portions in to get the desired rating for each portion.

Cycle 7
- CDOs include a mix of bonds and securities backed by mortgages and home equity loans. In 2006, an estimated USD100billion worth of subprime debt went into USD375billionin CDOs sold in the US.

Cycle 8
- Investors invest in CDOs because they offer higher returns than bonds given the same rating. Banks, insurance companies and pension funds take on more risks in pursuit of higher yields.

At the end, when housing property in US collapses, this led to many subprime borrowers defaulting their loans, thus causing a chain of reactions across the entire financial market!

The above event is a true classic result of human greed, as demonstrated by all parties who decided to be part of this high risk lending scheme, all with the hope of making huge returns.

As always, some degree of prudence is desirable in any investment decisions.