I came across an explanation of the effect sub-prime loans are having on the current investment environment. Written by Clarke Lanzen Skalla, I have selected the core elements to include here.
Q: What is a sub-prime loan?
A: These loans are made to individuals that have either no credit history or a high probability of default. Most of the problems we are seeing today, however, are in the adjustable-rate sub-prime loans, not the fixed-rate sub-prime loans. The delinquencies to date have been concentrated in those states that were subject to a lot of home price speculation.
Q: How widespread are sub-prime loans?
A: Sub-prime loans comprise about 14% of the first mortgage market. 13% of the sub-prime loans are late on payments. That means that defaults on sub-prime loans currently are about 0.6% of all first lien loans.
Q: Federal Reserve Chairman Ben Bernanke commented that those sub-prime loan losses could total $100 billion dollars.
A: If we were to incur $100 billion in loan losses in sub-prime loans, relative to the size of the US economy, that would place this "crisis" at approximately 1/5th the size of the Savings and Loan crisis back in the 1980's.
Q: Why is the stock market so concerned about sub-prime loans?
A: What happened is that these sub-prime loans were securitized or pooled into mortgage-backed bonds and sold to investors. The payment streams from these loans were divided amongst various tranches or buckets. Those tranches that receive their payments first are the highest credit quality. The lower tranches that are paid last have a much higher return and a much higher risk. These higher risk lower quality tranches, due to their potential high returns, were very attractive to hedge funds who borrowed heavily to invest in them.
Q: Why did these loans start to go sour?
A: Historically, the default rates on these loans were fairly stable. Hence, hedge funds would borrow heavily to invest in them to leverage their investment. Since the return profile was stable, they felt confident in that approach. Unfortunately, the Federal Reserve raised short-term interest rates 17 times and defaults in these loans increased from 10% to 14%.
Q: Why is this affecting the stock market so negatively?
A: Hedge funds are experiencing a high level of redemptions. Since there is not a liquid market for these sub-prime loans, they end up selling what they can, which means they resort to selling common stock or corporate bonds in an effort to meet the redemptions as well as de-leverage their portfolios.
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