Who Loses When Subprime Loans go Bad
SUBPRIME MELTDOWN
Here's how it's supposed to work
An individual takes out a mortgage from an originator. The originator sells the mortgage to a bank, which repackages the loan with others into mortgage-backed securities it sells to investors, shifting risk to others. The bank might also take "insurance" against the default of its subprime loans by entering a credit default swap. When defaults are low, lots of people win. Originators and banks make healthy profits and investors enjoy good returns on the bonds and derivatives tied to the loans. The only losers are those people betting on higher defaults.
Mortgage originators
When subprime loans start to default, mortgage originators such as New Century and Fremont are the biggest losers. They have to set more money aside for defaults, cutting into their profits. When loans go bad immediately -- and many did last year, as increasingly risky borrowers were given loans -- originators must buy those loans back from the banks that had planned to sell them as securities, another hit to their profits and balance sheets. Banks also lose interest in buying subprime loans, as demand for mortgage-backed securities dries up. Originators are thus left with bad loans and less cash to make new loans. Banks are also reluctant to loan them up-front money to give to borrowers. This toxic cocktail of bad debts and shrinking cash flow has resulted in the shuttering of more than two dozen subprime lenders in recent months.
Commercial banks and Wall Street firms
Banks such as Goldman Sachs, J.P. Morgan and Merrill Lynch, seem likely to fare better, as they are typically bigger and have more diversified operations. But as prices for mortgage-backed securities have fallen, they have been less able to repackage the subprime loans they get from originators -- so-called "slicing and dicing" -- and resell them for a hefty profit. They have forced some originators to buy back bad loans. But some originators have gone bankrupt or are unable to buy the loans back, leaving the bigger banks stuck with them. The toll on the big banks won't be fully known until they report earnings, though most analysts don't expect they'll suffer much.
Mortgage-Backed Securities
These are pools of mortgage loans divided up and resold as bonds to other investors. Banks sell them to offload risk, and investors buy them because they can be attractive investments, especially those backed by subprime loans, which have higher interest rates. But when problems bubble up, the highest-yielding securities are the first to falter. Hedge funds, insurance firms and even some of the big banks involved in buying subprime loans may have snapped up these bonds and could be at risk. No big losers have yet come forward. If problems in the mortgage industry worsen, higher-rated bonds could suffer, as well, potentially affecting more investors and drying up liquidity in the market.
Credit default swaps
These let mortgage holders buy insurance against defaults of riskier mortgages. The buyer pays the seller a regular payment, and the seller agrees to cover in the event of a default. Banks, hedge funds, insurance companies and other investors have taken both sides of this trade, betting for or against subprime defaults. No big losers in this trade have surfaced yet, but hedge funds such as Paulson & Co. and Balestra Capital have already reported big winnings by betting on higher defaults. Another way to bet on defaults is to invest in the ABX index, which measures the cost of CDSs on 20 subprime bonds. As the cost of insuring mortgage-bond holders against default risk has risen, the value of CDSs have fallen, and the ABX index has sunk, hurting investors betting that easy credit and low defaults would continue.
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