The complete guide to subprime for dummies (Part 2)

November 21, 2007

This is Part 2 of an on going series called, “The complete guide to subprime for dummies.” In the first part, I explained how an individual with poor credit gets wrongfully approved for a home mortgage.

But “wrongfully” is a subjective remark, and is currently up for debate. Many argue that subprime mortgage allowed homeownership to minority families that otherwise would not have had the privilege. But let’s save that discussion for later.

The other side of subprime: mortgage-backed securities

When Johnny, from our example in Part 1, purchases a house for $350,000 with a loan and added interest, he is actually agreeing to pay that loan multiple times over for a period of 30 years. Depending on the specifics of the contract, Johnny could potentially end up paying up to $800,000 over 30-year period. This is where banks make the bulk of their money — in the long-term.

But sometime banks do not want to wait 30 years for a contract to mature. So they seek investors who would buy these contracts and collect dividends as time progresses.

These contracts are not sold in its entirety to just one individual investor. It is divided into pieces and sold to multiple investors. These pieces are what is referred to as securities — in this case, mortgage-backed securities.

Most of the time, investors buying these securities have no idea who Johnny is and what house he is purchasing. There is not any transparency between the investors and the home buyer.

The investors can only go by the word of a credit rating agency that determine the quality of these securities.

Many of these subprime mortgage-backed securities were rated top quality by the credit rating agencies. Which consequently mislead investors into buying these securities they would otherwise think twice before purchasing.

3 Responses to “The complete guide to subprime for dummies (Part 2)”

  1. Kaj Johansson Says:

    Wealth emanates from production, material and immaterial, but certainly not from interest and banking smartness. You can, but should not, mix up real wealth with transfers from the poor to the already rich.

  2. Kaj,

    Boss, I wholeheartedly agree. Usury, to me, is one of the most disgusting crime a human being can commit against a fellow man.

  3. James Says:

    i like this blog. Cant waait for part four.

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