there’s big news in the markets this week. to understand what is happening to bear stearns, and the implications of the federal reserve’s actions, let’s start at the very beginning.
(in my head i hear maria’s voice from "the sound of music"- anyone else?)
sub-prime mortgages/sub-prime loans
these buzzwords have been at the root of much of this financial turmoil; but do we really know what they mean? here’s the straight story.
if you are interested in buying a house, you usually need a couple of things: 1. a good credit score (usually above 650 FICO score) and 2. a down payment that is usually between 10%-20% of the purchase price of the home. if you don’t have either of these things, you can still buy a home, but since you don’t qualify for a prime mortgage rate (this rate fluctuates, but has been around 5% for the past 5 years), you have to get a sub-prime loan. a sub-prime loan will have higher origination costs and a higher interest rate than the 5% you would get as a prime borrower, because you are more of a risk to the bank to lend to.
this is a really important lesson for us twenty-something’s who don’t really understand the importance of a credit score. in the financial world, your credit score is the single most important factor people look at when making financial decisions about you. take care of it! (i’ll post about credit soon)
many of these sub-prime mortgages take the form of adjustable rate mortgages, which is probably another term you’ve heard a lot about. an adjustable rate mortgage adjusts its rate (duh!) over time, so you may start out with a 5% mortgage that shoots up to 10% after 4 years. These can mean the difference between paying a $750 monthly mortgage payment for a couple of years and one day opening your mail to find out your monthly mortgage payment has shot up to $3,500. there is obviously great risk that the borrower will default in this situation, which the banks soon realized and created the derivative product of mortgage backed securities to spread the risk around.
this brings us to mortgage-backed securities, which i will unpack tomorrow. hopefully, by the end of the week we will all have a much better understanding of what is going on and more importantly, how this is going to affect us.
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