Sub-Prime Crisis

Annotations:

• A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. 

1. Prime Mortgages
   1. Mortgages issued to owners who are proven to be responsible citizens through proof of income and other documents through a downpayment
2. Sub-prime Mortgages
   1. Mortgages issued to an owner without the need for a downpayment, proof of income or any supporting documents

2. Receives monthly payments for each mortgage

1. Banks
   1. Supplied the other two parties with capital to borrow to carry out their activities
2. Mortgage Lenders
   1. Issued Mortgages to the homeowners
3. Investment bankers
   1. Bought thousands of mortgages from the mortgage lender and sold some to investors

1. sets aside some money from the bond interest to pay a Credit Default Swap (CDS) to

   Annotations:

   • Credit Default Swap: Ensuring a portion of the interest of a bond to a Bond Insurance Company to give the bond a higher rating.  The Bond insurance company would also repay the Bond buyer the principal he/she paid for their bond if the bond is defaulted
   1. Bond Insurance Companies

      Annotations:

      • Some examples of Bond insurance companies include: 1) Standard & Poors (S&P) 2) Fitch Ratings Inc. 3) Moody's investors service
      1. Rates Bonds with a good "BOND CREDIT RATING"

         Annotations:

         • Bond Credit Rating: A rating given to a bond to indicate its creditworthiness  A triple A rating (AAA) is the highest rating and is only given to the best investments

Annotations:

• CDO: Dividing the payments of the mortgages into Tranches.  When money from the mortgages are collected, the top tranches (Senior tranches/ AAA Rated bonds) would receive the money first. If any homeowner defaults from his/her mortgage, payments from the mortgages would stop thus the lower tranches (Junior Tranches/ CCC Bonds) may not receive any money

1. AAA
   1. Low Risk, Low Return
      1. Prime Mortgages
         1. Low Risk: Homeowners unlikely to default on their mortgages
         2. Low Return: Only source of income comes from the homeowner's mortgage payment
2. BBB
3. CCC
   1. High Risk, High Return
      1. Sub-prime Mortgages
         1. Why Invest in a high-risk bond?
            1. 1) If a homeowner is unable to pay off his/her mortgage, he/she would be defaulted from their mortgage
               1. 2) The property of the house would be transferred back to the
         2. High Risk: Homeowners are likely to default from their mortgages
         3. High Return: Usually carries a higher interest rate which translates to more money from a mortgage payment

Annotations:

• Foreclosure:  1) When a Mortgage owner is unable to pay back their mortgage 2) The Mortgage and property of the house then returns back to the one who invested in the mortgage. 3) When the investor puts the house back up for sale, it is called a Foreclosure

1. 4) And housing prices are always increasing

1. Supply of houses went up
   1. CAUSED HOUSING PRICES TO DROP (Bubble Burst)
      1. People were unable to pay back their loans and are forced to file for bankruptcy leading to....
2. Demand of houses dropped

1. After the Dot Com Bust of 2000, the FED overrode Anti-Predatory State Laws which allowed the lenders to connect homeowners to investors as this was stimulating the economy
   1. The overriding of laws also allowed lenders to create much riskier loans (Sub-prime mortgages)