Another important issue at play in the subprime crisis (and a major chunk of our current economic meltdown) is an item known as Mortgage Backed
Securities, or "MBS" for short. The practice is known as securitization.
The above posters have explained subprime, ARM, and other non-standard mortgage types fairly well.
(if you really want your hair to stand on end, option ARM mortgages are going to cause some serious high pucker factor here in the next couple
Not only were banks and brokers using non-standard mortgages to get people in houses, but banks found they could make a helluva profit if they did a
little dance called securitization with their mortgages.
In fairly simple terms: banks would take a stack of mortgages, let's say 100 of them. Of the 100 mortgages, maybe 40 of them would be "good"
mortgages with the borrowers having excellent credit and being very likely to pay the loan back. Another say 40 of the mortgages were "midgrade"
mortgages; maybe the borrower has only average credit, maybe they just barely came in over the income requirement. These mortgages are at a mild risk
of not being paid back. Then you have 20 mortgages consisting of subprime, ARM, option ARM, balloon, interest-only, etc; these are the bottom of the
barrel. These have a very high risk of not being paid back (default). Each of these different types of mortgages is called a "tranche" in this
Now, the bank bundles up all these different tranches into a group. Because of the number of "good" and "kinda good" mortgages, they are able to
have this group of 100 mortgages rated as a good credit risk. These bundles become Mortgage Backed Securities, or MBS.
Since real estate has been a fairly solid place to invest for a long time, these MBSs became popular in the investor market for their steady, high
returns. To put it simply: the bank can sell off the rights to payments homeowners make at a profit to them, which turns into even more of a profit
for investors. As homeowners make their mortgage payments, the investors gain profit.
As long as homeowners are making their payments, everyone up the chain continues to make money. When homeowners stop making their payments, though,
all the sudden investors are losing money. Some percentage of default is expected on MBS investment in a normal economy and because there are so many
mortgages involved the loss from normal default is negligible.
Now, the real Charlie-Foxtrot comes into play when we move back a couple steps to what I said about these MBSs being rated a good credit risk.
Investors were easily misled because they weren't aware of the sheer number of "toxic" mortgages they had effectively paid for.
When the housing bubble burst, and when the subprime mortgage tranches (which were the first to go) started to go into foreclosure, all the sudden
these "safe" investment vehicles began to go south. As more subprimes defaulted, investors (and investment firms) started to hemorrhage huge
As the subprimes really got into the worst of the defaults, the "kinda good" tranches started to default as well due to prevailing economic
conditions. The losses continued to mount.
That puts us about where we are now; the subprimes have failed along with the other "worst of the worst" and the midgrades are starting to fail now.
The next domino in line are option ARMs
; this huge batch of mortgages will
begin to default in full force early in '09 and are expected to peak in '10. This will mean even more money lost for those stuck with the MBS