1. Subprime mortgages or mortgages that are normally made out to borrowers with lower credit ratings (below 640) are viewed by the lender that the borrower has larger-than average risk of defaulting on the loan and as a result typically carry a higher interest rate than that of a conventional loan. Banks originally required a down payment from subprime buyers and normally kept these loans bearing the risk of default. Overtime banks began to group subprime loans into Residential Mortgage Backed Securities (RMBS) and large investors began to buy out these RMBS, passing the risk of default along to the investors not the lending banks. Additionally, the Credit Rating Agencies (CRA) gave the RMBS their highest ratings of AAA, making the RMBS appear to be safe investments. The banks then began to bundle the RMBS together into Collateralized Debt Obligations (CDO) and together with the rating agency they determined large portions of CDOs to be AAA rated, despite the fact that they were backed only by subprime mortgage loans. CDOs became highly popular and grew in numbers, however it became more difficult to find enough subprime loans to back new CDOs. Insurance contracts were then made, known as the credit default swap (CDS) and allowed the banks and investors to bet on subprime RMBS and CDOs without actually owning anything. This became a “betting game” of trillions of dollars for financial institutions as to whether or not home mortgage borrowers would default on their loans.
From my point of view, I feel that initially the financial engineers who first issued subprime CDOs did not intend to generate a large revenue profit margin from the grouping of the subprime loans. Instead it was sought as a convenient way to restructure and pass along the risk factor in the issuance of the subprime mortgages. (Involving more parties and minimizing negative outcomes or losses). However, it soon became a rolling and growing game for the financial...
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