Will the Subprime mortgage industry bring down the rest of the economy?

A Subprime mortgage is a loan granted to a borrower with a less-than-perfect credit report. Subprime borrowers have either missed payments on a debt or have been late with payments. Some even foreclosed on previous homes or declared bankruptcy. Lenders charge a higher interest rate to compensate for potential losses from customers who may run into trouble or default. To reduce their monthly mortgage payments some borrowers choose interest only or adjustable rate products which can be dangerous when interest rates rise and home values fall as we see today. When rates rise so does their monthly payments putting these borrowers at risk of defaulting on their payments. If their home values fall then it would be tough to sell their homes especially if they are in an interest only loan where no principle is being paid down which can result in negative equity. They owe more than the home is worth. But what is all the hype about with these subprime loans? Well for the institutional market this can have a ripple effect throughout the markets.

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There are approximately six million subprime mortgages in the USA. The average home price is $190,000. This comes out to $1.14 Trillion in subprime debt. Let’s round that down to $1 Trillion both for simplicity and the assumption that many of these loans are on lower-end houses. These loans are packaged up, along with non-subprime loans into Collateralized Debt Obligations (CDOs). The CDOs are then sold to institutional investors such as pension funds and hedge funds.

Based on the numbers above, a 1% drop in home values would then equate to a $10 Billion loss of value in the underlying assets of these CDOs. While this might seem bad enough it’s actually far worse. You see, the funds buying these CDOs use them as collateral to borrow more money, which is then invested in more CDOs or other assets such as stocks and other bond assets. The total leverage being used is unknown but is in the neighborhood of 10 to 25 times the value of the underlying assets. So our $1 Trillion in CDOs equates to $10-25 Trillion in total assets whose prices have been supported by the underlying mortgages. This is just the beginning. It will cause severe downward pressure on all of the asset classes which have been pushed upward by the use of these financial instruments, including stocks, bonds and real estate. As bond prices are depressed, interest rates will rise across the board which will further exacerbate the problem as more Adjustable Rate Mortgages (ARMs) adjust upward.

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