Sub-Prime market and Consequences

What are sub-prime mortgages

Simply put, Sub-prime mortgages is practice of lending money to people with lower credit ratings. Prime lending is the normal lending practice and the rates of interest in sub prime would normally be a couple of percent more than a similar prime lending loan.

What is Securitisation

Securitisation is the process of converting future cash flows into tradeable bond like packages. These future cash flows can be anything from future home loans, student loans, credit card payments and even music royalties. Securities can be very useful as you can use the money that you were going to get in the future.

What happened in the current scenario

A type of security backed asset called collateralized debt obligation(CDO) based its future cash flow on sub-prime mortgages. With the default rates in the sub-prime mortgages rising the value of these CDO started falling exponentially. These securities which had a value of billions of dollars suddenly became useless. This created a massive credit crunch with banks not able to finance things with these securities. A slump in housing market caused a world wide credit crunch because in this global economy these CDOs were brought and sold by banks all over the world. The extent of damage caused by these CDOs is still not clear even after Banks around the world have taken big hits on their balance sheets in the financial quarter. There is a school of thought that suggests that Securitisation encouraged lax lending practices. 

(The Consequences of Mortgage Credit Expansion - Study link here)

What is the future of structured Financing

Even the most ardent opponent of Structured Financing and Securitisation will agree to the fact that it has brought a lot of benefits to economies across the world. To throw Financial engineering out of the window because of the sub-prime problems would be wrong. This quote from the Economist.com article stuck "So it may just be a matter of hanging on. As any punter in Las Vegas will tell you, every losing streak ends eventually, if you can only stay solvent for long enough."