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If you are interested in a more detailed understanding the sub prime meltdown,
the following is from the Wall Street Journal and provides a flow chart of how
loans are repackaged and sold to investors.




Here's how it's supposed to work

An individual takes out a mortgage from an originator. The originator sells the
mortgage to a bank, which repackages the loan

with others into mortgage-backed securities it sells to investors, shifting risk to
others. The bank might also take "insurance"

against the default of its subprime loans by entering a credit default swap. When
defaults are low, lots of people win.

Originators and banks make healthy profits and investors enjoy good returns on
the bonds and derivatives tied to the loans.

The only losers are those people betting on higher defaults. Click "next" to see
what happens when loans start to go bad.






Mortgage originators


When subprime loans start to default, mortgage originators such as New
Century and Fremont are the biggest losers. They

have to set more money aside for defaults, cutting into their profits. When
loans go bad immediately --and many did last year,

as increasingly risky borrowers were given loans --originators must buy
those loans back from the banks that had planned to

sell them as securities, another hit to their profits and balance sheets. Banks
also lose interest in buying subprime loans, as

demand for mortgage-backed securities dries up. Originators are thus left
with bad loans and less cash to make new loans.

Banks are also reluctant to loan them up-front money to give to borrowers.
This toxic cocktail of bad debts and shrinking cash

flow has resulted in the shuttering of more than two dozen subprime lenders
in recent months.



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Commercial banks and Wall Street firms


Banks such as Goldman Sachs, J.P. Morgan and Merrill Lynch, seem likely
to fare better, as they are typically bigger and have

more diversified operations. But as prices for mortgage-backed securities
have fallen, they have been less able to repackage

the subprime loans they get from originators --so-called "slicing and dicing" -
-and resell them for a hefty profit. They have

forced some originators to buy back bad loans. But some originators have
gone bankrupt or are unable to buy the loans back,

leaving the bigger banks stuck with them. The toll on the big banks won't be
fully known until they report earnings, though

most analysts don't expect they'll suffer much.





Mortgage-Backed Securities


These are pools of mortgage loans divided up and resold as bonds to other
investors. Banks sell them to offload risk, and

investors buy them because they can be attractive investments, especially
those backed by subprime loans, which have

higher interest rates. But when problems bubble up, the highest-yielding
securities are the first to falter. Hedge funds,

insurance firms and even some of the big banks involved in buying subprime
loans may have snapped up these bonds and

could be at risk. No big losers have yet come forward. If problems in the
mortgage industry worsen, higher-rated bonds could

suffer, as well, potentially affecting more investors and drying up liquidity in
the market.




Credit default swaps


These let mortgage holders buy insurance against defaults of riskier
mortgages. The buyer pays the seller a regular payment,

and the seller agrees to cover in the event of a default. Banks, hedge funds,
insurance companies and other investors have

taken both sides of this trade, betting for or against subprime defaults. No big
losers in this trade have surfaced yet, but hedge

funds such as Paulson & Co. and Balestra Capital have already reported big
winnings by betting on higher defaults. Another

way to bet on defaults is to invest in the ABX index, which measures the cost
of CDSs on 20 subprime bonds. As the cost of

insuring mortgage-bond holders against default risk has risen, the value of
CDSs have fallen, and the ABX index has sunk,

hurting investors betting that easy credit and low defaults would continue.



Sources: Michael Panzner at Collins Stewart, Kathleen Shanley at Gimme
Credit, John Vogel at Dartmouth's Tuck School of

Business, Mark Zandi at Moody's Economy.com


Research by Worth Civils