What's this 'credit crisis' about?

A number of you have e-mailed about the credit crisis, subprime mortgages, and other related topics asking what it all means.

A critical concept to understand that the media doesn't often talk about is the trend toward "securitization" of mortgages. In the old days, people would normally go to a local retail bank and meet with a loan officer to get a mortgage. This bank would then collect interest payments over the life of the loan. The loan officer would, in theory, carefully assess the risk of the loan in order to come up with an interest rate, because if the borrower defaulted, the bank would lose money.

That doesn't happen so much anymore. A whole new cadre of mortgage lenders (many of them now defunct) would loan money to prospective home buyers. But instead of keeping these loans on their books, they would group together these loans in a package and sell them. The borrower would make interest payments that would eventually go to the new owner of the loan.

When these lenders sold the loans, they no longer had any risk if the borrower defaulted. Perhaps this was one reason they aggressively marketed new mortgage products, that offered features like rates that would adjust after a few years or that required no downpayment. Riskier borrowers ("subprime" borrowers) were given loans, and for some reason, other financial institutions were buying these loans.

In the news, you may have heard of "write-downs" by many big banks. What this means is that the value of those loans they bought are not actually worth what they expected, since those riskier borrowers are defaulting.

The markets have been spooked by this. So what does this all mean for young borrowers? More to come in upcoming posts...