About Sub-prime Mortgage

How a sub-prime mortgage become an investment instrument:

(1) Home Buyers
Poor credit histories Americans buy homes by paying higher interest rates, to compensate for greater risk of defaut.
(2) Mortgage Brokers
About 70% of the mortgages were initiated by hardly regulated home loan salesmen who reel in borrowers w/o regard for their need for loan or ability to repay it.
(3) Sub-prime Lenders and Banks
Sub-prime loan specialists sell the debt to big banks, which then sell to Wall Street banks.
(4) Mortgage-backed Securities
Sub-prime loans are pooled and repackaged into mortgage-backed security like bond, and offer a return fr interest paid by borrowers. Less risky bonds grant investors priority to repayments, while holders of more risky bonds will be the first to suffer losses fr defaults in the mortgage pool.
(5) Securities' Ratings
The bonds are then given credit rating. Given a large pool of mortgages, it is unlikely tt all borrowers will default at the same time. So less risky bonds are given AAA ratings, ie "risk-free".
(6) CDOs
The mortgages bonds are then re-packaged again, along with other types of bonds and debt instruments into Collateralised Debt Obligations (CDO), which are bought by banks, insurance companies, fund mgrs, etc. However, not all CDOs contain sub-prime debt.
CDOs may offer higher returns than bonds with the same rating. However, the chance of default is higher than corporate/govt bonds.
(7) Where they go to
(A) Equity: No direct impact. Stock mkt is hit bcos of fears over further deterioration of the sub-prime mortgage sector.
(B) Bond: Some may hv included CDOs and mortgage-backed securities in their portfolio.
(C) Balanced Funds: A mix of shares and bonds.
(D) Hedge Funds: Some unit trusts are invested in hedge funds and may hv exposure to CDO and mortgage-backed securities.
(E) Money Mkt: S&P found tt some money mkt funds n the US hv some exposure to mortgage-backed securities.