| Subprime borrower: |
Has a few overdue credit card bills; goes to a storefront lender owned by a major bank; takes out a $100,000 home-equity loan at 11 percent interest. |
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| Mortgage lenders: |
Advertises for borrowers, fights for market share, drives in as many subprime loans, option ARM's as they can; sells everything they originate to investment bankers, whose demand for more loans has continually increased; assumes that housing prices will only go up... |
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| Investment banks: |
Buys loans like there's no tomorrow, packages these subprime loans into bundles (aka pools) - complex mortgage-backed securities with varying interest rates and characteristics called Collateralized Debt Obligations, (CDOs) - sells various "slices" to eager investors.
Arranges protection for investors - though not officially called "insurance" lest the deal would be subject to insurance regulations - but by using a "private contract" called a Credit Default Swap that passes the risk of a "default" to the "insurer". |
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| Insurer: |
Determines the risk of default is low, sees premiums to be made with little down-side, agrees to the Credit Default Swap, thus agreeing to cover (guarantee) more money than it could possibly pay out (from claims).
What are the odds? |
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| Rating agencies: |
Hired by the investment banker to issue a "rating" on basis of original quality of the loans plus the "insurance-like" Credit Default Swap that wraps everything together, signaling certain slices of the CDO as low risk (aaa), or medium risk (bbb), or high risk (ccc).
Ratings directly influence the pricing of CDO slices. |
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| Investors: |
Borrows more money from investment banker to load up on CDO slices; makes money from interest payments made to the "pool" of loans.
No one loses—as long as no one tries to cash in on the "insurance" or housing prices don't fall or borrowers don't stop paying their mortgages and walk from the property.
What are the odds? |
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