The complete guide to subprime for dummies (Part 3)

November 24, 2007

This is Part 3 of an on going series called, “The complete guide to subprime for dummies.” In Part 1, I explained how an individual with poor credit gets wrongfully approved for a home mortgage. And Part 2 covered the other side of the subprime mess — investors who purchased these subprime mortgage-backed securities.

In this section I will hope to explain what the “crisis” is in this so called “Subprime mortgage financial crisis” that we are going through. This will probably be one of the hardest for me to cover. Not because of the complexity of the situation. Rather, I don’t want to leave out anyone that is affected by Johnny (from our example in Part1) defaulting on his monthly mortgage obligations.

Subprime crisis

First layer: subprime borrower

This certainly is the most obvious victim. Johnny, from our example in Part 1, has probably barely been able to keep up with his two monthly mortgage payments. It’s very likely that once the rate on his ARM mortgage has risen, he would be obligated to default (stop making payments altogether).

So when Johnny’s house is foreclosed on, his plight isn’t simply that he is suddenly homeless, he must now worry, too, about being able to afford to live anywhere else. Since almost all of his paycheck was going towards the mortgage, Johnny might not have enough saved in his bank account to even afford advance payment to be able to rent.

Additionally, the foreclosure will ruin his credit score enough to never get approved for future loans again.

As if that wasn’t enough, If Johnny’s mortgage company is anything like those that specialize in these type of subprime loan, then they deceptively haven’t been paying his property taxes. Which despite foreclosure, is Johnny’s responsibility.

Second layer: subprime securities investor

“A sure thing,” is what these investors were essentially told. Since the credit rating agencies’ approval was the only indication of these securities’ worth all that one could go by, no one suspected enough to investigate further.

In retrospect, these certainly weren’t high grade securities, as they were declared, but the very opposite — junk bonds.

Third layer: you, your community, United States

When a house forecloses, all properties lose value within a given mile-radius, depending on the region. Which presents two problem.

First, in your community,

lower property values translate into less revenue to fund schools, hospitals and other government-funded programs. (SFBizJournal)

Secondly, Americans have the habit of spending money taken from the equity in their homes. The equity changes proportionately to the property value. So the housing slump is bound to have a negative effect on this trend. Note: 2/3 of the country’s economy is generated by consumer spending.


I could add a fifth and six layer too — how the banks are suffering, and how the whole world lost its faith in the face of always shiny American economy. Or I could’ve explained other aspects in further detail– why exactly the dollar lost its value or how hedge funds leveraged to buy these securities (essentially buying borrowed money with borrowed money). But all above stated, I believe, conveys the message: “There must be immediate actions taken to address the crisis.”

We must take that action with extreme caution, too, though. Because although there is enough blame to go around — home buyers, loan officers, mortgage banks, credit rating agencies, investors, Alan Greenspan — implementing constraint regulations onto them could cause undesired results beyond the current.


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

  1. chachaji Says:

    Nice summary of the subprime crisis, Shlok! Enjoyed reading through it. Seems to cover all the basic issues.

  2. Thanks chachaji! That was my intention — informative yet simple. I just noticed you got your blog up and running too! Congratulations, can’t wait to check it out.

  3. kdawg Says:

    This was a great summary for those looking for simple explanations. Thank you for the time spent writing this up!

  4. Thank you KDawg. I appreciate you stopping by.

    And if I may recommend, do take a look at the two videos on the rail to the right. That is PBS’ Bill Moyers interviewing NYTimes’ Gretchen Morgenson on the subprime crisis. This was the only video (for months!) on the Internet that showed up when you typed in “subprime” on the all the video search engines. And yet it still is the only one that explains it best.

    If you have the time, I would suggest you read these two of Morgenson’s article that I believe initially brought the crisis to the forefront:

    Can These Mortgages Be Saved?
    Inside the Countrywide Lending Spree

  5. SG Says:

    Thanks for the very clear explanation of the subprime mess…very easy to understand and brings to light major issues the US will face in the long-term (and already facing now!)

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