You may have followed recent media coverage of the problems impacting the subprime sector of the mortgage market. Below is a basic overview of the issue and answers to frequently asked questions.
The Basics:
Subprime Mortgages are mortgages that have been made to homeowners with poor credit histories. These borrowers may be more likely to default on their loans than other homeowners since they already had financial problems before taking on their mortgages. After a subprime mortgage has been issued, the issuing bank often sells that loan to investors. Because subprime mortgages are higher risk, they typically pay higher yields to lenders (investors) in return for assuming that additional risk. Attracted by the higher yields, many mutual funds and hedge funds have invested in these loans often through CDOs (see below) or similar structures.
Collateralized Debt Obligations (CDOs) are structured products that pool multiple debt securities together, such as mortgages or bonds, and then issue debt collateralized by the pool. The debt issued by the CDO will vary by risk and credit rating. Investors in CDO debt can decide to purchase higher rated, less risky debt or lower rated, riskier debt.
The structure of the CDO may allow a pool of relatively low rated mortgages or bonds to produce higher rated debt. There are two primary ways this can occur:
1. The structure may require that higher rated debt has first call on incoming cash flows. Lower rated debt gets paid only after the higher rated portions are completely paid off. This means that almost all of the debt would have to default before investors in the high rated debt would take losses.
2. CDOs are typically constructed so that the debt securities that they hold as collateral, such as bonds and mortgages, have low correlations to each other. This is designed to reduce the overall risk of the portfolio.
FAQs
What’s the current situation?
Over the last 6 months many subprime mortgages have become delinquent as homeowners have run into financial difficulty. This has hurt hedge funds and others that have invested in these mortgages.
How does this activity impact the markets?
Higher defaults in the subprime part of the mortgage market may cause investors in other parts of the mortgage markets to demand higher risk premiums, which could drive down the prices of investment grade mortgages and bonds.
However, it is unlikely that defaults will actually rise in other parts of the mortgage market since credit-worthy borrowers should be able to service their loans as long as the economy remains strong and unemployment remains low. Higher defaults are likely to be limited to those who had financial weaknesses before they took out their mortgage. Therefore, it appears that investors in higher rated mortgages or CDOs have little cause for worry with regard to the current status of the subprime market.
