How it started

A couple of people have asked me what this sub-prime stuff is, so here goes.

Most people pay their debts. In fact the vast majority do, and those credit card companies which offer you a card even if you've got judgments against you make good money.

There was a lot of money washing around the American banking system, following the US government's having loosened monetary policy after 9/11 (in case there was a run on the banks) and not tightened it again, and the banks decided to lend money to sub-prime borrowers (a euphemism - everyone is sub-prime, it means dodgy) ie lower their credit standards, knowing that most people pay their debts.

Here's the good bit. The banks are regulated as to how much they can lend without raising more capital, but they wanted to do more of this stuff (egged on by the mortgage brokers who, not taking any risk themselves love it), so they sold the loans they had already done, trousering the fees, natch. That is to say they put Fred Bloggs' mortgage and Jack Sprat's mortgage into a company (the asset of the company is the right to receive interest and repayment from Fred and Jack) with thousands of others and sold the company. OK so far. Most people were paying their debts so the default rate was low and the company worth not much less than the total of the mortgages. There are thousands of these companies with billions of $ of loans in them.

The people who buy the company borrow money to do it. The debt they issue (ie their IOUs) is rated highly by the credit ratings companies because the original loans had collateral in Fred and Jack's houses (these IOUs are called collateralised debt obligations or CDOs, meaning not actually with collateral but with the flavour of collateral) and these CDOs are floating round the market attached to all kinds of other clever financial products. That is to say they are owned by people far removed from the mortgage business.

The rest of the saying is this: Most people pay their debts if they can afford to. Interest rates shot up in the US and the first people who couldn't pay were the sub-primes, obviously. And their houses, the collateral, weren't worth much now, obviously. But the people who lent them the money have sold it off so they won't lose. These rickety instruments are in small German savings banks, London charities, your pension. So whilst the ratings agencies say that only 1% of the stuff they rated has turned out to be Triple-Z rather than Triple-A, the effects are multiplied by leverage (people borrowing money to buy more and more and using the CDOs as collateral) and some new products no-one really knows how to account for, and we are all in shtook.

The borrowers aren't to blame, nor the lenders, really. Greenspan, the ratings agencies, the lack of supervision. It's a mess. We'll get out of it but there will be some tears on the way.