Why The Subprime Crisis Came About...

This is one of the best explanations of the subprime crisis I've seen to date, and is from a banker. The first part, which has less to do with the sub primes, is here. Thumbs up to the blogger...

What was/is the problem?

The fundamentals of banking are, in reality, rather simple: if you want to get money from the bank, they need to know the likelihood of you paying that money back. The more likely that is, the less you will have to pay for that money. If you have savings and want to invest that money, the higher the interest rate, the greater the likelihood that you will not see any of your money back.

The banks live on asymmetric information (if the borrower could tap the lender directly, they wouldn't need the bank!) and fees for services provided. They pay interest rates on savings that are lower than the rate they charge to borrow that money, and the interest difference is where they make their money (service fees serve only to lower their overhead). They can turn their liabilities (unpaid loans) into assets by discounting the future value plus repayment risks and selling their portfolio at a discount. You normally don't do this, as the banks want the cash flows. It's their bread and butter.

So, what happened in the sub prime crisis?

The banks no longer needed to worry about whether the money got paid back. They jiggered their internal rating systems to make all loans look good, misrepresented those loans to external investors, and laughed all the way to the ... bank. They were more than happy to do so, since if one had properly discounted the loans, they'd have been true junk, with maybe ten cents on the dollar. So they broke even and cashed in on their fees.


The external investors invested like they believed that all sub primes were actually prime loans, and were overcome by one of the most fundamental human emotions: greed. They thought they were getting solid investment instruments with great rates of return, and I cannot fathom why their due diligence failed so abjectly.


The borrowers were complicit and stupid. On the one hand, the banks were actively looking for such folks, and normally would never, ever have lent them these monies, but since the bank was selling the loan immediately, it didn't care: someone else would pay the bill.

So, it's a tragedy: billions "lost", careers ruined, homeowners evicted, and this will cost probably around 50-75 points of GDP growth for the next several years each and every quarter until the mess is cleaned up and proper banking re-emerges.