Dow Jones Industrial Average suffered more than 600-point loss in the pass three days mainly due to the overly pessimistic market sentiment from the hike in oil price and fears over the Sub-Prime fallout!

So what exactly is Sub-Prime mortgage? How does it become an investment instrument that caused this big problem we now see?

It all started with the secured homeowner loans taken up by home buyers with poor credit histories. Some Americans buy homes which they could not afford by paying higher interest rates, to compensate for the greater risk of default. Most lenders will only offer unsecured loans to those with decent credit. If you have a good credit history and rating you will be able to enjoy a good choice of personal loans from a variety of lenders, which means that you can find a loan that suits you in terms of repayments, interest rates, and terms and conditions. What an irony!

In fact, about 70% of the mortgages were initiated by hardly regulated and irresponsible home loan salesmen who reel in borrowers without regard for their need for loan or ability to repay it. To cover themselves, the Sub-prime loan specialists sell the debt to big banks, which in turn sell to the much bigger Wall Street banks.

Eventually, these Sub-prime loans are pooled and repackaged into mortgage-backed security like bond, and offer a return from interest paid by borrowers. Less risky bonds grant investors priority to repayments, while holders of these more risky bonds will be the first to suffer losses from defaults in the mortgage pool.

The bonds are then given credit rating. Given a large pool of mortgages, usually it is unlikely that all borrowers will default at the same time. So less risky bonds are given AAA ratings, i.e. “risk-free”.

The mortgages bonds are then re-packaged again, along with other types of bonds and debt instruments into Collateralised Debt Obligations (CDO), which are bought by banks, insurance companies, fund managers, etc. However, not all CDOs contain sub-prime debt. CDOs may offer higher returns than bonds with the same rating. The chance of default is higher than corporate/govt bonds.

What worries me most is that some money market funds in the US have some exposure to mortgage-backed securities as well. Money market funds were originally invented to offer investors better returns than bank savings accounts while providing a high degree of safety.

This post is sponsored.

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