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A Simple Explanation of the Subprime Crisis Part 1
Published by DavidWaring
12-03-2007 |
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#1
By
Unregistered
on
02-27-2008, 12:01 PM
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Hi David,
Brilliantly presented explanation of the Subprime Crisis! Got a question. As far as I understand a mortgage is a method of using property as security of an obligation, which is other words is a guarantee that if the borrower doesn't pay, then runs risk of foreclosure of the mortgage by the bank to recover the debt. Any amounts received from the sale are applied to the original debt, but in this case I take it that the amounts received from the sales must have been quite significantly lower than the initial loan after the bubble burst in order to have originated this gigantic worldwide crisis. Do you know how creditors are dealing with the sale of properties held in guarantee? Is it simply the difference between initial loan and the received sale price that has originated this whole subprime crisis or is it that properties aren't selling and banks are stuck with them? Thanks, Anthony |
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#2
By
David Waring
on
02-27-2008, 03:21 PM
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Quote:
Good question. Yes a mortgage is a secured loan which means that the loan is secured by the the property which will be foreclosed upon by the lending institution if mortgage payments are not made. This is in contrast to unsecured loans, the best example of which is credit card debt. While if you do not pay your credit card bills the lenders can come after you, they do not have rights to a specific asset and therefore it is much harder for them to recover their losses. A couple of points to note here to answer the other part of your question. In the past banks have required a borrower to put down 20% of the value of a house upfront so that the bank is protected if the borrower does not pay. What this means basically is if say they make a loan to someone to buy a $100,000 apt that person puts down $20,000 and the bank lends them the other $80,000. In this case if the borrower does not pay their mortgage payments the bank can come in and foreclose at which point it has a house that is hopefully still worth at least $100,000. This gives them plenty of breathing room to sell the property and get back the full $80,000 they loaned. In recent years however as liquidity has increased as outlined in my videos, banks have become more aggressive with lending to people who put less than 20% down and in the subprime space in particular were even making loans to people as aggressive as no money upfront. So this obviously gives the bank a lot less breathing room if the property is foreclosed upon to sell that property and recoup their full loan amount. As property prices have been falling in a lot of areas recently and more and more people default the financial institutions that are holding these loans are often times stuck in a situation where they foreclose on a property that is not worth and they cannot sell for enough to get back the full they have loaned. So yes this is a problem but there is actually a bigger problem than this. When these loans are packaged up and sold as outlined in the second video in this series on the subprime financial crisis, what the buyers of those mortgage pools are buying is the rights to the future principle and interest payments on all the mortgages in that pool. So if a borrower whose mortgage is in that pool defaults not only does this cause a potential loss because of what I have outlined above but it also causes a potentially much larger loss to the holder of the mortgage pool due to the loss of the future interest income on that asset. As the typical mortgage is 30 years most of the time the amount that a borrower pays in interest on the property they buy over the life of the loan is more than the value of the property when they bought it. Now when these mortgages are packaged up and sold in these large pools, the sellers of those pools and the buyers of those pools use financial models to try and predict the amount of people who are going to default on their mortgage over the life of all that pool as well as how many are going to prepay their mortgage or pay the mortgage off before the end of the loan which would also result in a loss of the future income on the loan. Once they have estimated this they take that data and this is how they come up with a value for the mortgage pool. So now that we understand this we can understand the bigger problem here which is that a lot more people are defaulting on their mortgages than the buyers of those mortgage pools were thinking would, so they are now taking huge losses on those pools which are assets to the financial institutions that own them as they have to mark their value down to current market valuations which reflect the increase in defaults. Hope that explains it a little better. If there are any other questions or comments on the US subprime crisis please feel free to post them below. Best Regards, Dave |
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| Tags: market , mortgage , subprime crisis explained |
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