Sub-Prime Mortgage Lenders - The Big Short

According to Michael Lewis, in his book The Big Short, not only were mortgage lenders lending to folks who couldn't afford the loans, they were providing second mortgages so that borrowers could tap equity in their homes (not to buy houses) allowing financiers to expand their business into the largest asset base in America, housing.

Lenders claimed that these products allowed the sub-prime borrowers to finance purchases at lower interest rates instead of using high interest credit cards. Although this is partly true, it allowed borrowers to take out second mortgages on trailers which much like cars, begin to lose their value the second you drive it off the lot.

In the 80s, mortgage bonds were divided into tranches in order to bucket off the risk of "prempayment." (Note: repayment and not default was viewed as the chief risk. The individual in the first tranch was synonymous to a person on the first floor of a house during a flood. They would get hit first if the loan was paid off early thus eliminating their cash flow, leaving them holding the bag when typically, interest rates were at a low. The next person would be on the second floor and get hit second but would realize a lower interest rate payment. So on and so forth.

As the subprime market began lending out second mortgages to the owner's of trailers (again folks, anything on wheels generally depreciates over time) the tranches were established to account for default risk. The person on the first floor receives a higher interest payment but gets hit first. The person on the second floor is next, followed by the third, so on and so forth ... just like a giant set of dominoes.