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Corporate Advisory Insight: Making Sense of Subprime Part 1 Phil Abram from Thomson Financial's Corporate Advisory Services group discusses the subprime (More) Phil Abram from Thomson Financial's Corporate Advisory Services group discusses the subprime situation. Transcript: Bubbles bursting; credit crunching; 2007 was the year subprime slammed the markets. I'm Phil Abram, bringing you Thomson Financial's "Making Sense of Subprime." The word subprime is tossed around casual finance conversations all the time these days, but what does it actually mean and why should you care? Simply put, a subprime mortgage is a loan that's issued to borrowers with a higher-than-average risk of defaulting on payments. In exchange for taking on the added risk, lenders charge higher interest rates on these loans than they do for conventional mortgages. Borrowers pay the higher rates because they have no other option, while for the lender; higher risk yields a higher return. In order to stimulate the economy in 2001, the U.S. Federal Reserve cut interest rates to their lowest levels since the 1960s. With these cuts, the price borrowers paid for home loans decreased creating high demand for homes in the U.S. While yields on loans dropped, lenders, at the same time, offered mortgages with extended amortization periods and adjustable rates with the expectation that higher rates later would subsidize lower rates now. The problem was the artificial confidence that the bull market created in the minds of borrowers. From 1996 to 2006, the share of subprime mortgages to total home loan originations rose from 9% to 20%. Misguided borrowers mistakenly opened adjustable lines of credit and continuously refinanced their mortgages believing that the run would continue and their homes would only increase in value. Instead, rates began to rise and home values started to fall in 2006 leaving borrowers unable to make payments and lenders stuck with property worth less than the loan. Defaults and foreclosures have risen to such a level that in October of 2007, 16% of subprime loans with adjustable rate mortgages were 90 days delinquent or in foreclosure, triple the number of defaults at the same time two years earlier. By January of 2008, that number rose further to 21%. But how does trouble between homeowners and mortgage lenders find its way directly onto Wall Street? The answer is through mortgage backed securities and CDOs. Lenders began packaging risky mortgages into investment grade securities traded between banks, corporations, hedge funds and other investors, and most of which were given triple A ratings. Now, once the bubble burst and borrowers defaulted, those investors were left with billions of dollars of securities with little or no value. As of January 25, 2008, major U.S. banks and other financial institutions reported roughly $130 billion in subprime related write-downs. Investors then backed away from buying commercial paper altogether and corporations ultimately found themselves without a source to raise capital and balance sheets riddled with worthless short term investments. The economic trickle down from there is simple. Corporations are forced to close segments or cut jobs, the cuts create unemployment, unemployment hinders spending, and slow spending pressures the entire economy. That's all for now, but for more, stay tuned for the next installment of our series "Making sense of Subprime." (Less)
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