Keeping up with Financial Fashion

Every few years, there will be a financial term that takes the world by storm and is spouted by at least a few billion people on a daily basis. In the 1930s, it was The Great Depression; fast forward to 1997 and you hear Asian Crisis; in the early millennium years it was Dot-Coms.

Now we have Sub-Prime. It is the single most over-used and least understood financial term in recent years. Hence I shall venture into treacherous territory where few emerged unscathed. My breakdown of 'sub-prime' may irk the financial purists out there but my purpose, as always, is to tell the story as simple and as pretty as happily-ever-after-possible.

Let me tell the story of Sub-Prime in 5 abridged, non-fictional and moving chapters.

Chapter 1: US Property Boom
Property prices escalate, leading to a buying frenzy, with everyone wanting a piece of the pie, hoping that prices will continue to shoot and they can sell it off for a hefty profit within months, if not years. So good old Jack buys a very handsome mansion for a $1.25 million bucks.
The Problem: Few people, in fact almost none, buy property with cash. So good old Jack pays a down payment of 20% and takes out a 20-year mortgage loan of $1 million dollars.

Chapter 2: Banks Trade with Banks
Banks love to re-package loans and sell it off to other banks to generate some cash flow. Banks also love to buy packaged mortgaged loans as they promise long term regular payments. Mortgage loans are usually given safe ratings like 'AAA'.
The Problem: With the property boom in Chapter 1, banks are easier with mortgage loan applications and people with bad credit or people with unstable incomes will not find it too hard to secure a sub-prime loan which charges a higher interest rate than normal. The default risk of the loans are significantly higher yet are still labeled 'AAA'.

Chapter 3: Bubble Bursts
Property prices stop escalating and even starts to drop. People find themselves stuck with a piece of property they have no use for and some choose to default on their loans (especially those stuck with sub-prime interest rates, hence the term). Banks take over the defaulted piece of property.
The Problem: The valuation of property has dropped and banks make hefty losses. Poor old Jack's mansion is only worth $600,000 now and were he to default on the $1 million loan, the bank will make a loss of $400,000. Multiply this by the number of people defaulting and you get the idea.

Chapter 4: Infecting other Banks
Banks who have given out loans or bought the packaged loans from the aforementioned banks suffer losses and have to write off billions of bad debt.
The Problem: Institutions like Bear Stearns are too much in the red and are susceptible to takeovers. Perhaps it could have avoided its fate had they named in Bull Stearns.

Chapter 5: Where Next?
Most analysts speculate that we're witnessing the worst recession in the US for decades but the fundamentals in Asia are fine and should be spared from the worst.
The Problem: We never know what will happen for sure, not even good old Jack.

There. Now you can walk out of your house proud because you too, can tell the story of Sub-Prime in 5 chapters.
Extra comments by Tau: Well, in local context, you would also like to know that the Sub Prime crisis probably would not happen in Malaysia or at least not in the same form as it is in the US mainly because there is no rollover and re-resecuritization(repackaging of loans) of mortgages. Mortgages are only securitized once in Malaysia, whereas for the US, the loans would be sold off to one bank/financial institution, who would then RE-sell it off to another bank/FI, who would RE-re-sell it on, thus when real estate prices declined and borrowers defaulted, it started off a chain reaction that affected many FIs in with a knock on effect, sending the investment banking industry spiraling out of control.

Another factor was that mortgages were long term based loans causing assets to be tied up long term, whereas FIs needed money in the short term to run the day to day business and settle operational costs and short term debts, this caused a mismatch in payouts leading to liquidity issues in a market that is already unwilling to create any credit, thus putting the nail into the coffin.