What is the US subprime mortgage problem — explained in simple terms
August 17, 2007
Global stock markets are down, investors are on selling mode, and almost all of 2007′s stock gains have been wiped out. The culprit, analysts say, is the current US subprime lending problem.
The subprime — what? And if it’s supposed to be a problem in the US, why is it affecting markets in Europe and Asia?
A simplified explanation of the US subprime lending problem can be found below.
What are Subprime Loans or Subprime Mortgages?
These are loans or mortgages made to homeowners with poor credit ratings. Loans made to these people are of considerable risk because these borrowers are more likely to default on their loans since they already had financial problems before taking on the loan.
After the loans are issued, issuing banks usually sell these loans to investors. The process of repackaging these loans to become another form of investment asset is “securitization.” To compensate for the high risk, these securitized loans typically pay higher yields. Attracted by the higher yields, a number of mutual funds and hedge funds in the US invested in these loans.
What is the current Subprime Lending Crisis?
Beginning in late 2006, many subprime mortgages have become delinquent as homeowners run into financial difficulty. More than two dozen subprime mortgage lenders have already failed or filed for bankruptcy due to rising incidents of subprime foreclosures.
How is this affecting the markets?
A number of hedge fund companies and investment banks that invested in subprime loans incurred millions of losses or even went bankrupt due to the subprime lending problem. The possibility of tightening credit conditions also caused volatility and panic in the US stock market, which consequently sent fears to European and Asian markets, major trading partners of the US. The possibility of the US falling into recession is driving world stock markets to their recent lows.
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