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America's road to recession and the "sub-prime" scapegoat

The problem of sub-prime mortgages is a difficult one with no easy solution. Perhaps it would be best to begin with a brief description of the difference between these loans and more normal mortgages. The regular method of obtaining a home mortgage requires a credit check, verification of income (which must be adequate to make the payments), and a down payment (generally around 20%). The mortgages called sub-prime are missing one or all of these elements. It is difficult to imagine a bank lending $150,000 to someone to buy a house or anything else without some assurance that the loan will be repaid.

Some banks offered interesting twists on the normal mortgage, such as the adjustable-rate mortgage (ARM). This type is similar to the "teaser" rate that credit cards offer. The interest rate is low when you first take out the loan but it may rise in the future. At that point the house payment you have been struggling to make is now significantly larger. Mortgages were offered and accepted in some cases with no down payment. That practice, along with granting a loan without verifying the applicant's income, is in direct contradiction to standard practice.

It stands to reason that home loans that fall into the "exotic" category would be classified and managed differently from the normal mortgages. Apparently, they were not. It is a longstanding practice among lenders that mortgages are routinely sold to other institutions. What started happening a few years ago, however, was something very different. Mortgages were bundled in large numbers and financial institutions bought pieces of these bundles. The buyer would not own a mortgage but rather a small piece of many mortgages. Many of these sub-prime loans were bundled into the same packages as conventional loans. They were classified AAA, meaning low risk. The banks did not know what they were buying but other banks were buying them (and making money in the process of buying and selling) so they assumed they were safe investments.

The bank executives were persuaded by some very inventive traders that they could make significant amounts of money by investing in these bundles of mortgages. They were also persuaded that the risk was low because it was spread out over a large number of institutions. They bought and sold credit default swaps, collateralized debt obligations, mortgage-backed securities, and some other very esoteric instruments. Nobody knew with any accuracy

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