Subprime for Dummies
Imagine a financing company accepting loans from people like me and you. Before they accept your loan, they would first have to confirm that you are ?credit-worthy.? They have to make sure that you could pay them with the added interest because that is how they earn. In plain common sense, why would they loan out cash to people whom they know can?t pay them? They know if we are able to pay by asking for our proof of income, asking other finance companies or banks about your behavior in the finance world and also asking for you Income Tax Return and salary advices.
In my simplest terms now, this distinguishes the ?prime? customers from a ?sub-prime? one. Prime being those who are credit worthy and Sub-prime being the opposite.
Now, for some financing companies now, they accept loan applications from people like me and you but with a much more attractive bargain for us. Some of them don?t look into the person?s ability-to-pay anymore. Have you ever received spam emails saying ?Your credit has been approved, click here to claim $xxx,xxx.xx.? Also, you might see ads like ?0% interest on the first year? but if you read the fine print, it says that you?d have to pay larger interest in the succeeding years. The people who are attracted to these ads are normally the customers classified as ?sub-prime.? Many individuals now are happy that they could loan without presenting ?proof of income.? For purposes of my discussion, I would focus more in these sub-prime loans.
Now these loans can actually be traded or sold to other finance companies and banks. So now, we could consider individual?s loans as a ?product.? Just like any other product like clothes, perfume and food, you need to sell or market it. Now the loans will be more attractive if they have collaterals. Collaterals are assets pledged by a borrower to a lender that in case they could not pay the loan back in cash, the finance company would have the right to the asset pledged. The most common collateral for these time in the US (and anywhere actually) is real estate (house and/or lot).
Now that the loans are attractive, they group and pool them all together. So all in all, it could sell these loans made by 30 individuals to banks. Banks usually don?t buy only a single loan, they buy usually in groups. Now the bank, thinking that the loans being sold are attractive and has even collateral, they buy it. So technically now, the bank has the right to collect the payments that the individual borrowed from these finance/mortgage companies. Along with this right comes the risk that these individuals could not pay.
Then here comes reality. The individual borrowers get more and more exhausted in paying for the money that they borrowed from the mortgagers. The 0% interest is a light burden in the first year. But in reality, you?d have to pay more interest in the succeeding years. With this, the individuals have to divide their humble income into two: (1) payment for debt; and (2) money for their daily expenses.
As time goes by, these individuals default from their payments since in the first place, in strict common sense, they could not afford it.
Now the banks affected didn?t know that these loans are sub-prime. They are just assured that they are collateralized with real estate. Now, the reality happening everywhere among many banks is that they ?write-off? these sub-prime loans as a loss. Meaning, they could not recognize profit from these loans anymore. Their money outflow from buying these loans could not be returned by a money inflow anymore.
Since these loans are collateralized, the banks have the right to the real estates pledged on the mortgage. But these are already hard to sell and are liquid.
Before I really understood the sub-prime and new just bits about it, I asked a colleague who happened to be an economist. ?The economy technically is at crunch but isn?t it just valid to think also that the economy is still at balance? I mean, if the banks lost a lot, someone must gain a lot? Right? It doesn?t sound right to think that the economy turned bad because banks lost money. Shouldn?t we consider the gainers?
He probably didn?t get my question because I couldn?t explain it very well to him. So he just kept on saying that ?the economy is down right now ? period.?
Well, after the training, I found the answer to my own question. First, who are the gainers? It?s those smart mortgage companies. They are the ones who earned and took advantage of this. Why? They already sold their claims. They already converted those loans into cash. Now for my weird question about economic balance: yes, the economy lost ?material money? in one point-of-view and it gained in another. The term that I used to is ?material money.? I know it sounds redundant. But, we forget to consider the ?intangible money.? And, my personal definition of ?intangible money? is future money and future income. All this is lost because these two important ?intangibles? are compromised: Goodwill and Trust from the bank?s stakeholders.