Why would bank invest in subprime mortgages if they are so risky?

Question

There has been much discussion of subprime lending in the most recent month.

Answer 1

Okay...real answer...from an "insider".

Banks were able to generate more income...at what they believed to be less risk...with "packaged" underwriting of loans.

HOW and WHY?

It is NOT the bank lending "directly" to subprime lenders that is the problem here....and that is where most people understand this INCORRECTLY.

What happened in the "financial community" in the last few/several years was a bit of "re-inventing the wheeel" as far as how many of the lenders (including banks) got money for their mortgage loans.

For the most part...banks and wall street investment firms that were doing mortgages, in the recent past, have very little subprime loan concerns.....as far as the % of subprime rated loans they did "directly". Banks, Investment Firms, and many mortgage companies kept within a specific ratio of how many subprime loans they did versus the amount of "B" paper, and "A" paper loans. (How they classify the better quality credit loans.) The "key", and the source of the "real" concern comes elsewhere.

Wall Street...came up with a "new" way of generating funding for the many mortgages being made in the "low rate boom" or the 'lower rates period' we just came out of. (Rates are still historically quite low, people are just a bit spoiled lately...with no memory of "real history".) What happened was an idea of how to improve the "credit rating" of what would otherwise have been subprime loan ratings into a higher, more acceptable risk quality, "loan package".

By taking multi-millions-of-dollars of loans and "packaging" them into a large group of "aggregate" (grouped together) loans...they were able to spread the "default risk" of the subprime loans accross a number of "mid" and "high" (A &B paper) quality loans...thus raising the "average" credit rating of the "package" and raising the "credit quality" of the whole package. Since the credit rating of the "group paper" was now higher...institutions that would normally never invest too much money into subprime quality paper...did. Essentially, they bought into the "story" of how much "less risky" these packages were.

Take, for easy to understand purposes, 100 loans.
20= subprime loans (...and ALL subprimes DON'T default!!!).
45= "B" paper loans...mid-grade...average credit loans.
35= "A" paper loans...High grade...above avg credit people's loans.
100= loans with a "smattering" of subprime loans mixed in...and since only a percentage of subprime loans default (don't pay/go bankrupt) then the "package" still only has a small percentage of default risk...a higher risk of default than if ALL the loans were "A &B" paper...but much less risk to investors than if ALL the loans in the package were subprime!

The "investors" in collateralized mortgage obligations (C.M.O.s), also known as Collateralized Debt Obligations (C.D.O.s) are the ones with a higher level of risk for having a "portion" of their "package" defaulting on their payments... and/or the principal of that portion of their loan being resold/resolved for less than the property is worth.

Mind you...what the "crisis" is based on is an assumption of an ever-increasing % of subprime loans held by banks, wall street firms, and mortgage companies..defaulting. Not just the traditional number...but more than average...because of the "rising adjustable rate loans resetting soon."

Since banks...among other companies and institutions..."may" have invested in "more than usual amounts" of CMO/CDO packaged loan debts...they would also have "skirted" their own internal standards of how much subprime paper they could have "on the books" right now. It's not that there's a great risk of "complete" default from these loans...it's that there could be more "loss of income" from the defaulting loans...and more "loss of principal" from homes being resold for less than the amount of the outstanding loan within the % of loans that are held by the "investors" (banks/wall street/independent mortgage companies).

Independent Mortgage companies, who DO NOT have the same lending restricting that banks and wall street firms do...are the primary concern...because they, of course, have a much higher % of loans on the books that fall into "subprime" than the banks do. Another IMPORTANT element is.....the banks are where the mortgage companies got the money for "funding" these loans!!! SO, if the independent mortgage companies go bankrupt...or have a SIGNIFICANT amount of loans defaulting...then they may default on some of their loan repayments back to the banks...the banks then have to write off even more losses than their "direct" lending risks accounted for...and so on, and so on....this is the "house of cards" risk that CNBC is referring to.

And this LENGTHY answer....contains the overwhelming majority of the concerns...and reasoning...behind what the risk is to the banks...and where it came from.

Answer 2

Wow MJM. What an answer! One thumbs up doesn't seem enough.

If I could add my tuppence worth here. It seems that this crisis has only come to the fore because of the real possibility of house prices falling.

This has happened in some areas of the US and the worrry is it will become a general phenomenon. In many areas in the UK price rises have slowed to a standstill.

Now I suspect that, on average, subprime borrowers tend to borrow a larger percentage of the property value than those with better credit ratings. So in any downturn it is the subprimes who will reach negative equity first.

The model of securitisation of these loans works so long as it is possible to repossess the properties and reclaim the money lent. This may not now be the case.

The biggest problem is that iit is difficult to quantify the risk.

Answer 3

There are 3 reasons a bank would invest in sub-prime mortgages:

1. The interest rate will be higher than less risky loans.
2. There is political pressure for banks to lend money to poorer people.
3. They are desperate to get more business.

The current World-wide credit crunch is primarily the result of the second reason arising from the US government's pressurising banks to lend money to Ninjas.

Answer 4

its all about the money!! they charge a hell of a lot more interest on sub prime than on prime products to compensate for the higher majority of people in this sector that dont pay, but yes they can come unstuck when their forecast figures turn out to be wrong and more people than they expect dont pay their instalments, but the banks will always come out on top eventually, the sub prime market is EXTREMLY lucrative

Answer 5

Because they can charge much higher rates of interest
but it can go very wrong if the economy isnt doing well

Answer 6

Try going to this site, they have lots of information about this sort of stuff.

Answer 7

greed