Sub-Prime

Not too long ago, an uninformed individual once said “UK banks are in trouble because they lend to sub-prime borrowers”.

Since the last summer, sub-prime has become the hottest topic within the financial market. The topic became so ‘hot’, that even an Ah Pek out of nowhere declare his intelligence of the issue itself. Let me get this straight. To certain extend, UK banks do lend to sub-prime borrowers (although the definition of sub-prime borrowers is completely different from US). But it is not lending to sub- prime borrowers that got the UK banks into trouble. It was investing in these loans that got UK banks in trouble.

What is sub-prime?

Simply put it in layman’s term, if you lend money to someone considered as sub-prime, likelihood you can kiss your money good-bye or scream ‘chebye’ or both. That’s because sub-prime refers to people who are potentially unable to repay the loan due to lack of income, default history etc. So if you lend money to my dog, you can say ‘chebye’.

However, since the interest rate is fairly low during the early 2000s, US banks began to aggressively lend to sum-prime borrowers who wants to purchase houses (the low interest enable these sub-prime borrowers to make the monthly repayment). Further, US was experiencing housing boom at that time, so even if sub-prime borrowers default their loan, the banks could repossessed their house, which the value continue to increase. As such, there is no risk to their loan.

You’ve been talking about US. What about UK?

To increase the US banks’ profit, they decide to sell their mortgage to other investors and earn a fee while spreading their risks. This is done by taking a pool of loans (inclusive of sub-prime loans) that the banks loan out to, and sold these loans to investors say for example, as bond (I am keeping this simple). Since these sub-prime loans are mixed together with ‘good’ loans, they are graded better than junk bonds. When people repay the loan, the proceeds will go to these investors. Some of these investors include UK banks.

Here is where the shit hit the ceiling. When interest rate increase and sub-prime borrowers couldn’t repay the loan, this is going to affect the investors who are holding bonds (which consist of sub-prime loans). To make matter worse, the increase in house price over the last few years became unsustainable and it finally dive. So, when sub-prime borrowers default, the value of the houses is insufficient to repay the outstanding loan. When, sub-prime borrowers couldn’t repay the loan, don’t expect the investors to get anything.

So, to set the record straight, UK banks didn’t lend money to sub-prime borrowers like US. But they did invest in sub-prime (one way or the other), which is why they get into trouble when the sub-prime problem explodes.I am being simplistic here just so that non-finance background people could understand.