OCTOBER 2007 :: COVER STORY : ECONOMICS

Subprime Time
Behind the Scenes of the Credit Crunch

Why is the crisis in subprime lending happening? And why is it a big deal?

To answer this, it helps to understand how the mortgage market connects with other financial markets, and why subprime loans-loans that target homebuyers with shaky credit histories or little savings-even exist.

A conventional home mortgage is a contract between a borrower and a lender. The lender agrees to lend a homebuyer a certain sum of money, say, 80% of the purchase price of a home. The home buyer agrees to pay back the loan, plus interest, in regular monthly installments over a specified period of time. The borrower also pledges to forfeit the house to the lender if he cannot repay the loan. The amount of the loan, the interest rate (which can be fixed or fluctuating), the repayment term and the collateral are all spelled out in the mortgage contract. Once the home purchase is closed, the buyer gets the keys to the house, and the lender can count on receiving a steady stream of monthly interest and principal payments over the next 30 years, hoping that the borrower doesn't default.

But the lender also has some other options. For instance, it can sell the loan. That means it transfers the mortgage contract to another company, giving that company the right to collect those monthly interest and principal payments. In exchange, it accepts a lump-sum payment. Selling a loan can be a highly attractive option. It allows the lender to pocket all the fees it collected from the borrower when it made the loan, while it largely escapes the risk of the borrower defaulting on the loan later on. And it now has more money available to lend to other borrowers. This is the key incentive for subprime lenders to make loans that would otherwise be considered too risky.

Who buys these loans, and why would they do so? Subprime lenders lately have been reselling loans in bulk to Wall Street banks. The bankers, in turn, pool large batches of loans together and convert them into interest-paying bonds that can be sold to investors. Once again, the Wall Street banks get paid upfront (rather than waiting 30 years), and the risk of default is shifted and dispersed to the millions of investors who buy the bonds.

In recent years, such "mortgage-backed" bonds have attracted investors from all over the world, because they have paid investors a better interest rate than other comparable bonds. Although each of the bonds represents many small, risky mortgage loans, the investors care much more about the overall qualities of the bonds-things like the average credit score-than the credit profiles of the individual home-loan borrowers.

Among the most active investors in these bonds have been "hedge funds," private investor pools that manage money for wealthy, sophisticated investors. Hedge funds invest enormous sums, but they, too, rely heavily on bank loans to help finance those investments, expecting to pay back the big loans with even bigger investment profits. So in effect, the money that a subprime home buyer borrows for his home is really coming from a bank that is several steps removed from the transaction.

And this is where things have gotten messy lately.

For several years, hedge funds were performing very well, and were able to invest more and more money into mortgage-backed bonds, which, down the line, made more money available for subprime lenders and, ultimately, home buyers. But amid the recent troubles in the housing market-with flattening home prices and rising loan delinquencies-many of those investments have gone sour. Now, hedge funds are having trouble getting capital from banks to fund their investments in mortgage-backed bonds. With less demand for the bonds, Wall Street banks are less inclined to buy up loans from subprime lenders. And that leaves subprime mortgage companies with more risk on their hands and less money to lend. Many subprime lenders have gone out of business.

In this way, the trouble in the housing market spreads all the way up to banks and investors who have little connection to or knowledge about their borrowers. And the resulting squeeze on capital trickles all the way back down to lenders, homeowners and prospective buyers, making it especially difficult for subprime borrowers to get new loans or refinance their old ones.