You have equity in your home and you want to borrow money but you have a less than stellar credit history. You apply for a mortgage loan in a subprime market.

If you had good credit you could get a mortgage loan for let’s say 7%. Let’s say you have $200,000 equity in a $300,000 home and you want a loan of $100,000. A local credit broker loans you the money thinking the house could drop in value 30% and he could still foreclose and get his money. He charges you an interest rate of perhaps 12% plus a few points closing.

The 12% yield is attractive to investors, and is ‘safely’ secured by the house. Typically a subprime borrower will borrow in this market for a few years, rebuild his credit rating to apply for a prime loan, and then pay off the sub prime loan. The loan costs therefore must be amortized over a short period, hence the higher rates and fees.

Wall Street sees the higher yields, likes what they see, buys them up from the knowledgeable local brokers and packages them in units to sell to investors, keeping some of the higher yields. In fact the fees become so lucrative that they throw lots of money at brokers to find more of these rich yields. Prudence is sacrificed, appraisals become inflated, the local touch is lost.

Bankruptcies happen, the safety spread has diminished aggravated by a soft housing market and more aggressive lending practice, and now principle disappears (along with principles). Banks and brokers that packaged these sub prime loans show record defaults, Wall Street panics.

A few lessons- what works locally does not always work nationally. What may work in small units does not always work with larger numbers. When the fees to originate loans become too lucrative there will be incentives to inflate values and make loans work that should never have been put on the books.

The local broker used to see his investors at the grocery store and in church and had an incentive to be sure the loan performed. The Wall Street whores rarely had to look their investors in the eye.

The subprime meltdown was the result of a good investment vehicle with a limited market that was destroyed by Wall Street throwing too much money at it. It wasn’t the first time.

And it won’t be the last.

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