From Thomas L. Friedman (Hot, flat and crowded) p 9 to 24. This is a summary of him. I've part quoted and part re-stated, (although not made it clear which is which!)
It all started with dodgy mortgages; they seem to come in two breeds:
Subprime (which is also used generically to describe both sorts)
The borrower has a blemished credit history and low scores on tests used to estimate credit quality.
Alt-A Loans
Mortgages that have low initial interest rates, but then go to higher rates in a year or two. They require no or low down payments. The borrower does not have to state their income or their stated income is not verified (wow!); hence they are sometimes called "liar loans". That said the borrower could have a good credit history...it seems these loans were used by "speculators" thus:
A speculator buys a house with an, initially, cheap Alt-A loan and then sells it on when the higher rate kicks in and takes the capital gain as profit. Of course, this only works when the housing market is good (rising prices and high demand).
Subprime (and Alt-A) mortgages historically represented only a small part of the mortgage market; they had always existed alongside the lower risk "Prime" mortgages (where the borrower has good credit history and proven, stable income to meet mortgage repayments).
Default on prime mortgages was historically less than 4% in the US; during the crisis defaults on "subprime" loans was around 30%.
The growth in subprime mortgages was driven by several factors:
1. A key factor was the American governments desire to encourage home ownership. The government encouraged entities like Fannie Mae and Freddie Mac to make mortgages more available, speciaifally by using "flexible underwriting standards" (Friedman's quotes, he doesn't state his source though).
How widespread was it:
In September 2008 there were roughly twenty-five million of subprime and Alt-A mortgages with unpaid principal totaling around $4.5 trillion (that would make the average unpaid principal $180,000). That's almost 45% of all single-family mortgages in the US in 2009.
How dodgy were the borrowers?
"people with incomes of $15,000 to $20,000, with no credit ratings, or in some cases without even a steady job or citisenship papers were granted mortgages to buy $300,00 and $400,000 homes"
How these mortgages were sold on
A bank or mortgage broker sold the mortgage to a borrower. The institution then sold the loan on to bigger financial firms (think Citibank, Merrill Lynch and the government sponsored bodies Fannie Mae and Freddie Mac).
The big financial firms bundled the mortgages together and sold them as bonds. The idea being that the mortgage repayments could be used to pay interest and capital to the bond holders. The bonds appear to be asset-backed (meaning that they are guaranteed by the bricks and mortar of the house the original mortgage is on).
The bonds were popular; they were well rated by the ratings agencies and historically Americans had been good at repaying loans. Hence, the bonds were bought by fund managers all over the world.
What happened next...
The housing market collapsed. Prices went down and presumably demand did too. This meant people who were speculating with Alt-A mortgages couldn't repay the loans by selling. They also couldn't meet the higher interest payments that kick in after a year or two. Similarly, sub-prime borrowes
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