Subprime Mortgage/Toxic Assets/Junk Bonds

These terms are bandied about on the news all the time, but do you know what these terms really mean?

If not allow me to quickly enlighten you of what they are;

As mentioned on my previous entry commercial banks needed to find alternative ways of raising capital in order to be able to keep up with other banks and offer competitive lending rates.

One way of generating money, banks used the performances of existing mortgages and packaged it as bonds for people to invest in.

Prior to the financial crisis, the housing market was experiencing a boom with record house prices. And as a result Sub-prime bonds were extremely popular for investors. Sub-prime bonds contained a pool of mortgages that were considered 'High Risk'. By high risk it means that the bond consist of a portfolio of mortgages where there is a high chance of the mortgage defaulting.

So why would people be attracted into investing in these Sub-prime mortgages or junk bonds?

The high risk of failure is counterbalanced by the high interest rate offered by banks. As house prices continues to rise, high risk Mortgage bonds is an acceptable risk for investors to take. For example if one mortgage defaults, the high price banks will receive from the resale of the house will offset the costs of loan defaults

So as the US housing market boomed these bonds became extremely popular with investors and banks continued issuing these bonds to investors and used their money to finance more loans. Thanks to High Risk Mortgage Bonds, the finance industry made an absolute killing!

Mortgage bonds are made up of thousands of home loan, so even if there are a significant batch of dodgy loans, the value of these bonds should be protected through diversity. As banks continued to prosper, people in the financial industry became increasingly cavalier in the way they package their Mortgage Bonds. To make these bonds even more attractive, bankers offered even more generous interest rates by packaging bonds consisting only of mortgages with poor credit rating. And then to achieve profitability banks seemingly gave out loans like as if they were going out of fashion. Therefore on many occasions banks gave out loans to people that had no means of paying back the loan.

Again taking such high risk is sustainable when property prices are high. However when there is a price boom, there is bound to be a price bust. With an oversupply of houses in the market, housing prices started to fall. So without high house prices, when loans go bad the value of mortgage bonds will fall.

An increasingly frequent sight in the United States

So in a nutshell, the economy is in this mess because when people started defaulting on their loans these sub-prime bonds essentially became worthless or TOXIC. And since sub-prime bonds represented billions of dollar of a banks capital, the banks capital stock essentially got wiped out.

And since every bank in the US acted the same as one another, before any government bailouts were given out, all banks were essentially skint for cash. This in turn freezes the credit market halting economic growth but more importantly it threatens the public's trust in banks.