[Caveat: This is not meant to be a scholarly piece and in the interests of time I will not be citing/linking articles. Consider it a commentary from someone in the markets - I hope it is useful.]
Anyone reading headlines or watching the news should have realized that the equities market has been usually volatile in recent weeks and the word "subprime" has been thrown around like F-bombs in a vintage Eddie Murphy stand-up performance.
What is SUBPRIME?: "Subprime" refers to various types of loans, typically mortgages, made to consumers whose credit and/or credit history did not qualify them for the typical 30 year amortizing loan on 80% of a property's value.
In the old days, people plunked down 20% of the selling price as down payment on a house and borrowed 80% that was typically paid out over 30 years. Banks would check credit history, look at income and if the price paid for the property were reasonable make the loan. They would then earn the spread between say a mortgage at 7% and pay out 3% on deposits.
That started to change in the early 1990s with the advent of the mortgage-backed securities market. [Go read Liar's Poker by Michael Lewis - a truly outstanding book] Instead of banks holding on the mortgages, they packaged them into securities and resold them. This allowed banks to issue more mortgages as they no longer had to a) service them b) have them sit on the balance sheet. This was GOOD for everyone as banks could issue more mortgages and most of these mortgages were (are) AAA rated. (Now Monk and I might not qualify as AAA borrowers BUT combine 1,000 of us together and you have pretty good diversity.)
Fast forward ten years later. The market is booming. Americans are doing well but we like to live at or beyond our means. That starter house is starting to look shabby and we want that 4 bedroom McMansion that Toll Brothers is putting up. A bank might balk at our qualifications but non bank lenders like Countrywide and American Home Mortgage have found that there is money to be made by making riskier loans to borrowers on the margin. They are more aggressive allowing 10% or perhaps even 5% down payment. There are more interest-only loans where the consumer doesn't amortize the principal - for the moment. Further, borrowers can take advantage of a low rate environment by committing to adjustable rate mortgages like 2/28 ARMs where you get a super-low, e.g., 4% rate for the first two years and then have refinance.
WHY WOULD ANYONE LEND MONEY IN SUCH A RISKY FASHION? "Lender" has become a misnomer. These firms aren't really lenders they are really more "packagers". Within weeks or a couple months after the loan is originated it is securitized and diced up into securities that are bought by the market.
WHO WOULD BUY THIS STUFF? Good question. EVERYBODY. One of Wall Street's dirty little secrets is they are pretty much all YIELD WHORES. Basically for an extra 10, 25 or 50 basis points (100 basis points = 1 percent) they are willing to take on much more risk.
CREDIT DEFAULT DERIVATIVES was a market that boomed in the past 3-4 years. This market allowed folks to buy and sell insurance on bonds defaulting. The original idea was to allow owners of corporate bonds to buy some insurance against default in lieu of trying to sell bonds at a fraction of their cost if conditions for a firm suddenly deteriorated.
What happened was folks, including many hedge funds, found that writing this insurance was profitable - especially as the economy was doing quite well and defaults were very low. So investors were able to buy these higher yielding securities AS WELL as insurance.
However things snowballed and got out of hand and lending practices started to lose sight of economic reality. Combine that with home prices starting to level off and then decline in 2006. Folks start to default because their property is already underwater so they stop making monthly payments. Loans that have been committed but haven't been packaged or sold off are now the equivalent of toxic waste. Holder of repossessed homes are trying desperately to offload.
Now this whole exercise is very upsetting for Main Street because NEW HOME SALES are a huge driver for the economy. The economic activity derived from building a new home to the appliances that are bought to outfit it to the furniture that is bought by new owners is critical to the economy. The subprime shock is a terrific body blow to an already weakening homebuilding sector which has increasing inventory of built but unsold homes as well as holding a lot of land at very high prices.
So are we in danger of FINANCIAL ARMAGEDDON? I don't think so. The true subprime market is only about 10-20% of the mortgage market and not nearly all of it is in default or truly toxic. The yield whores holding this paper and many subprime lenders are getting hurt. However, major financial institutions will probably take material hits in earnings but it is unlikely that any of them are in jeopardy. The market is very concerned about liquidity at the moment since the market on these securities has largely stopped trading and raising funds for ongoing operations via asset backed commercial paper or for margin calls is difficult.
However, the European System of Central Banks as well as Federal Reserve have 'shown the flag' via significant injections of liquidity over the past week and while the market may not be as confident with Bernanke as they were with Greenspan I think most seasoned players are looking at his as a bad patch rather than a swamp.
Also the fact that Henry Paulson, former CEO of Goldman, Sachs, is Treasury Secretary and not John Snow should not be underestimated.