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A credit crunch primer

BOYD ERMAN

Globe and Mail Update

August 22, 2007 at 12:12 PM EDT

Q: What is a subprime mortgage?

A: It's a mortgage given to a home-buyer with less than stellar credit, or who lacks the paperwork to prove an income that can support payments. While such mortgages may not seem like the greatest idea, lenders flush with money were making loans in the U.S. to almost anyone who asked and charging a little more in interest for riskier loans. The bet was that rising U.S. house prices would paper over any mistakes.

But when U.S. housing prices started to fall, and interest rates began to rise, many borrowers ended up in trouble and lenders started to become insolvent (at last count about 50 have been wound down).

Q: Who were those lenders?

A: There were specialty finance companies such as American Home Mortgage (which filed for bankruptcy earlier this month), as well as big well-known banks such as HSBC PLC (which is still standing, but weakened after its U.S. unit took a big profit hit on subprime loans).

Q: How did the problem spread from subprime lenders into the rest of the financial world?

A: Many of the companies that were making the subprime loans weren't holding onto the loans, but instead sold them to other parties, including hedge funds and pension funds looking for higher returns. Often, the loans were packaged together (think of a mutual fund holding thousands of individual loans) and sold to investors.

When those loans started going bad, suddenly lots of people all across the financial world were affected. Concerned about losses, investors and lenders started demanding higher interest rates to make loans, or stopped doing so entirely. Thus began the credit crunch.

From consumers, who are finding mortgages have now become more expensive and tougher to get, to massive buyout funds such as Kohlberg Kravis Roberts & Co., which are having to pay more for loans to carry out takeovers, tougher credit terms are slowing purchases and that's slowing the economy and hurting stocks.

The latest problem has surfaced in the asset-backed commercial paper market.

Q: What is commercial paper?

A: Commercial paper is short-term debt issued by companies, usually coming due in under a year and often in as little as a month. Buyers tend to be institutional investors such as money-market mutual funds, low-returning funds where investors park cash in the belief that they are safe. As a result, only highly rated companies with strong balance sheets can generally issue commercial paper, limiting the size of the market.

Q: What is asset-backed commercial paper?

A: To feed the appetite of the growing fund industry for more commercial paper, financial companies such as Coventree and National Bank of Canada set up trusts that issue commercial paper backed by assets such as car loans, mortgages and credit-card receivables. Most of these trusts roll over a portion of their commercial paper every day.

Q: How big is the market?

A: It's worth at least $120-billion in asset-backed commercial paper alone. About two-thirds of that paper is sold by trusts run by banks, and that segment of the market is holding up. About another third, or $40-billion, is issued by trusts created by non-bank financial companies such as Coventree, and those have suddenly gone “no-bid” — Bay Street lingo for “nobody will buy at any price.”

Q: What's happening in the market?

A: Suddenly, portfolio managers at money-market mutual funds are asking whether they really want to be investing in commercial paper that is backed by assets such as mortgages when the housing market is going bust. As a result, the trusts can't find buyers for their paper, leaving them short of money.

They are turning to banks, such as Deutsche Bank AG, that had agreed to provide loans in a situation where the market flounders, but some of the banks are balking. The trusts could end up being wound up.

Q: What does it mean for my money-market mutual fund?

A: If a money market mutual fund is invested in a trust that is in trouble, it could spell losses in a fund that most investors probably bought precisely as a way to insure against losses. But, so far it's only a small slice of the market that's in trouble, and not every money market fund holds paper issued by the troubled trusts.