Dozens of mortgage lenders declare bankruptcy in a matter of weeks. The market is filled with concerns of a major global credit crunch. which could affect all classes of borrowers. Central banks use emergency clauses to inject liquidity into scared financial markets. The real estate markets plummet after years of record highs. Foreclosure rates double year-over-year during the latter half of 2006 and in 2007.

The reports sound intimidating, but what does all this mean?

We are currently knee-deep in a financial crisis that centers on the U.S. housing market, where fallout from the frozen subprime mortgage market is spilling over into the credit markets, as well as domestic and global stock markets. Read on to learn more about how the markets fell this far, and what may lie ahead.

The Path to a Crisis

Was this the case of one group or one company falling asleep at the wheel? Is this the result of too little oversight, too much greed, or simply not enough understanding? As is often the case when financial markets go awry, the answer is likely all the above

Remember, the market we are watching today is a byproduct of the market of six years ago. Rewind back to late 2001, when fear of global terror attacks after Sept. 11 roiled an already-struggling economy, one that was just beginning to come out of the recession induced by the tech bubble of the late 1990s. (For related reading, see The Greatest Market Crashes and When Fear And Greed Take Over .)

In response, during 2001, the Federal Reserve began cutting rates dramatically, and the fed funds rate arrived at 1% in 2003, which in central banking parlance is essentially zero. The goal of a low federal funds rate is to expand the money supply and encourage borrowing, which should spur spending and investing. The idea that spending was patriotic was widely propagated and everyone — from the White House down to the local parent-teacher association — encouraged us to buy, buy, buy.

It worked, and the economy began to steadily expand in 2002.

Real Estate Begins to Look Attractive

As lower interest rates worked their way into the economy, the real estate market began to work itself into a frenzy as the number of homes sold — and the prices they sold for — increased dramatically beginning in 2002. At the time, the rate on a 30-year fixed-rate mortgage was at the lowest levels seen in nearly 40 years, and people saw a unique opportunity to gain access into just about cheapest source of equity available. (For related reading, see Why Housing Market Bubbles Pop and How Interest Rates Affect The Stock Market .)

Investment Banks, and the Asset-Backed Security

If the housing market had only been dealt a decent hand — say, one with low interest rates and rising demand — any problems would have been fairly contained. Unfortunately, it was dealt a fantastic hand, thanks to new financial products being spun on Wall Street. These new products ended up being spread far and wide and were included in pension funds, hedge funds and international governments.

And, as we’re now learning, many of these products ended up being worth absolutely nothing.

A Simple Idea Leads to Big Problems

The asset-backed security (ABS) has been around for decades, and at its core lies a simple investment principle: Take a bunch of assets that have predictable and similar cash flows (like an individual’s home mortgage), bundle them into one managed package that collects all of the individual payments (the mortgage payments), and use the money to pay investors a coupon on the managed package. This creates an asset-backed security in which the underlying real estate acts as collateral. (For more insight, read Asset Allocation With Fixed Income .)

Another big plus was that credit rating agencies such as Moody’s and Standard & Poor’s would put their ‘AAA’ or ‘A+’ stamp of approval on many of these securities, signaling their relative safety as an investment. (For more insight, read What Is A Corporate Credit Rating? )

The advantage for the investor is that he or she can acquire a diversified portfolio of fixed-income assets that arrive as one coupon payment.

The Government National Mortgage Association (Ginnie Mae) had been bundling and selling securitized mortgages as ABSs for years; their ‘AAA’ ratings had always had the guarantee that Ginnie Mae’s government backing had afforded. Investors gained a higher yield than on Treasuries, and Ginnie Mae was able to use the funding to offer new mortgages.

Widening the Margins

Thanks to an exploding real estate market, an updated form of the ABS was also being created, only these ABSs were being stuffed with subprime mortgage loans, or loans to buyers with less-than-stellar credit. (To learn more about subprime, read Subprime Is Often Subpar and Subprime Lending: Helping Hand Or Underhanded? )

Subprime loans, along with their much higher default risks, were placed into different risk classes, or tranches. each of which came with its own repayment schedule. Upper tranches were able to receive ‘AAA’ ratings — even if they contained subprime loans — because these tranches were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk. All the way at the bottom, the equity tranche was a highly speculative investment, as it could have its cash flows essentially wiped out if the default rate on the entire ABS crept above a low level — in the range of 5 to 7%. (To learn more, read Behind The Scenes Of Your Mortgage .)

All of a sudden, even the subprime mortgage lenders had an avenue to sell their risky debt, which in turn enabled them to market this debt even more aggressively. Wall Street was there to pick up their subprime loans, package them up with other loans (some quality, some not), and sell them off to investors. In addition, nearly 80% of these bundled securities magically became investment grade (‘A’ rated or higher), thanks to the rating agencies, which earned lucrative fees for their work in rating the ABSs. (For more insight, see What does investment grade mean? )

As a result of this activity, it became very profitable to originate mortgages — even risky ones. It wasn’t long before even basic requirements like proof of income and a down payment were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being underwritten and given to prospective homeowners. The logic being that with real estate prices rising so fast (median home prices were rising as much as 14% annually by 2005), a 125% LTV mortgage would be above water in less than two years.

Leverage Squared

The reinforcing loop was starting to spin too quickly, but with Wall Street, Main Street and everyone in between profiting from the ride, who was going to put on the brakes?

Record-low interest rates had combined with ever-loosening lending standards to push real estate prices to record highs across most of the United States. Existing homeowners were refinancing in record numbers, tapping into recently earned equity that could be had with a few hundred dollars spent on a home appraisal. (For related reading, see Home-Equity Loans: The Costs and The Home-Equity Loan: What It Is And How It Works .)

Meanwhile, thanks to the liquidity in the market, investment banks and other large investors were able to borrow more and more (increased leverage ) to create additional investment products, which included shaky subprime assets.

Collateralized Debt Joins the Fray

The ability to borrow more prompted banks and other large investors to create collateralized debt obligations (CDO), which essentially scooped up equity and mezzanine (medium-to-low rated) tranches from MBSs and repackaged them yet again, this time into mezzanine CDOs.

By using the same trickle down payment scheme, most of the mezzanine CDOs could garner an ‘AAA’ credit rating, landing it in the hands of hedge funds, pension funds, commercial banks and other institutional investors.

Residential mortgage-backed securities (RMBS), in which cash flows come from residential debt, and CDOs were effectively removing the lines of communication between the borrower and the original lender. Suddenly, large investors controlled the collateral; as a result, negotiations over late mortgage payments were bypassed for the direct-to-foreclosure model of an investor looking to cut his losses. (For more, read Saving Your Home From Foreclosure .)

However, these factors would not have caused the current crisis if 1) the real estate market continued to boom and 2) homeowners could actually pay their mortgages. However, because this did not occur, these factors only helped to fuel the number of foreclosures later on.

Teaser Rates and the ARM

With mortgage lenders exporting much of the risk in subprime lending out the door to investors, they were free to come up with interesting strategies to originate loans with their freed up capital. By using teaser rates (special low rates that would last for the first year or two of a mortgage) within adjustable-rate mortgages (ARM), borrowers could be enticed into an initially affordable mortgage in which payments would skyrocket in three, five, or seven years. (To learn more, read ARMed And Dangerous and American Dream Or Mortgage Nightmare? )

As the real estate market pushed to its peaks in 2005 and 2006, teaser rates, ARMs, and the interest-only loan (where no principle payments are made for the first few years) were increasingly pushed upon homeowners. As these loans became more common, fewer borrowers questioned the terms and were instead enticed by the prospect of being able to refinance in a few years (at a huge profit, the argument stated), enabling them to make whatever catch-up payments would be necessary. What borrowers didn’t take into account in the booming housing market, however, was that any decrease in home value would leave the borrower with an untenable combination of a balloon payment and a much higher mortgage payment.

A market as close to home as real estate becomes impossible to ignore when it’s firing on all cylinders. Over the space of five years, home prices in many areas had literally doubled, and just about anyone who hadn’t purchased a home or refinanced considered themselves behind in the race to make money in that market. Mortgage lenders knew this, and pushed ever-more aggressively. New homes couldn’t be built fast enough, and homebuilders’ stocks soared.

The CDO market (secured mainly with subprime debt) ballooned to more than $600 billion in issuance during 2006 alone — more than 10-times the amount issued just a decade earlier. These securities, although illiquid, were picked up eagerly in the secondary markets, which happily parked them into large institutional funds at their market-beating interest rates.

Cracks Begin to Appear

However, by the middle of 2006, cracks began to appear. New homes sales stalled, and median sale prices halted their climb. Interest rates — while still low historically — were on the rise, with inflation fears threatening to raise them higher. All of the easy-to-underwrite mortgages and refinances had already been done, and the first of the shaky ARMs, written 12 to 24 months earlier, were beginning to reset.

Default rates began to rise sharply. Suddenly, the CDO didn’t look so attractive to investors in search of yield. After all, many of the CDOs had been re-packaged so many times that it was difficult to tell how much subprime exposure was actually in them.

The Crunch of Easy Credit

It wasn’t long before news of problems in the sector went from boardroom discussions to headline-grabbing news.

Scores of mortgage lenders -with no more eager secondary markets or investment banks to sell their loans into — were cut off from what had become a main funding source and were forced to shut down operations. As a result, CDOs went from illiquid to unmarketable.

In the face of all this financial uncertainty, investors became much more risk averse. and looked to unwind positions in potentially hazardous MBSs, and any fixed-income security not paying a proper risk premium for the perceived level of risk. Investors were casting their votes en masse that subprime risks were not ones worth taking.

Amid this flight to quality. three-month Treasury bills became the new must-have fixed-income product and yields fell a shocking 1.5% in a matter of days. Even more notable than the buying of government-backed bonds (and short-term ones at that) was the spread between similar-term corporate bonds and T-bills, which widened from about 35 basis points to more than 120 basis points in less than a week.

These changes may sound minimal or undamaging to the untrained eye, but in the modern fixed-income markets — where leverage is king and cheap credit is only the current jester — a move of that magnitude can do a lot of damage. This was illustrated by the collapse of several hedge funds. (For more on these collapses, read Losing The Amaranth Gamble and Massive Hedge Fund Failures .)

Many institutional funds were faced with margin and collateral calls from nervous banks, which forced them to sell other assets, such as stocks and bonds, to raise cash. The increased selling pressure took hold of the stock markets, as major equity averages worldwide were hit with sharp declines in a matter of weeks, which effectively stalled the strong market that had taken the Dow Jones Industrial Average to all-time highs in July of 2007.

To help stem the impact of the crunch, the central banks of the U.S. Japan and Europe, through cash injections of several hundred billion dollars, helped banks with their liquidity issues and helped to stabilize the financial markets. The Federal Reserve also cut the discount window rate, which made it cheaper for financial institutions to borrow funds from the Fed, add liquidity to their operations and help struggling assets. (To learn more, read Get To Know The Major Central Banks .)

The added liquidity helped to stabilize the market to a degree but the full impact of these events is not yet clear.

Conclusion

There is nothing inherently wrong or bad about the collateralized debt obligation or any of its financial relatives. It is a natural and intelligent way to diversify risk and open up capital markets. Like anything else — the dotcom bubble, Long-Term Capital Management’s collapse, and the hyperinflation of the early 1980s — if a strategy or instrument is misused or overcooked, there will need to be a good shaking-out of the arena. Call it a natural extension of capitalism, where greed can inspire innovation, but if unchecked, major market forces are required to bring balance back to the system.

What’s Next?

So where do we go from here? The answer to this question will center on finding out just how far-reaching the impact will be, both in the United States and around the world. The best situation for all parties involved remains one in which the U.S. economy does well, unemployment stays low, personal income keeps pace with inflation and real estate prices find a bottom. Only when the last part happens will we be able to assess the total impact of the subprime meltdown.

Regulatory oversight is bound to get stiffer after this fiasco, probably keeping lending restrictions and bond ratings very conservative for the next few years. Any lessons learned aside, Wall Street will continue to seek new ways to price risk and package securities, and it remains the duty of the investor to see the future through the valuable filters of the past.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature .