Subprime and the Subsequent Crash
Poor customers tend to have poor credit history. Commercial banks won't lend money to these customers. When these credit-risk customers want to buy houses, only subprime lenders are willing to give loans to them at obscene interest rates. Sometimes, these rates are as high as 22%.
Good credit customers can get mortgage loans for 5 - 7%. Poor credit customers will become poorer if they keep paying 22% to the loan sharks, unless otherwise their property values increase. Poor credit customers take the risk of paying 22% thinking that they would be able to sell the home for a profit.
When the subprime lenders lend the money credit-risk customers, they don't keep the loans. After few months, they package many loans into securities and sell them to financial institutions.
Banks don't lend money to credit risk customers. Ironically, they buy the subprime securities from subprime lenders.
When poor customers default on their loans, it has domino effect. If there is only one or two customers default, it's not a big deal. If there are thousands of defaults, it will be a big mess.
That's what happened this week in Wall street.
The market started showing more signs of subprime jitters when HSBC Finance, consumer lending unit of British banking giant HSBC Holdings said it was setting aside 20% more than analysts had estimated for bad loans in 2006 because of weakening in the U.S. mortgage business. Shares of the bank took the nose dive.
More bad news came from Irvine based lender New Century Financial. New Century, the second-largest subprime mortgage originator in the U.S., announced it would restate results for the first three quarters of 2006 to correct accounting errors related to loan repurchase losses, sending the stock down 30% on Feb. 8. The company expects to see a loss for the fourth quarter of 2006 due to early payment defaults.
All these subprime mortgage companies know that there is a real risk in lending to credit-risk customers. They still lend the money, because their business is very lucrative. Who else will pay 22%?!
Related Tags: mortgage, loans, credit, india, usa, subprime
Ram is the author many articles that cover Personal Finance and Business. You can read his articles at http://www.digitalbhoomi.in/blog
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