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Risky Subprime Market Sends Ripples Through Financial World

The volatility of the financial markets this summer has stemmed from weaknesses within the mortgage industry and other risky loan operations. Economics correspondent Paul Solman explains what is behind the subprime market and how it has impacted the financial world.

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  • PAUL SOLMAN, NewsHour Economics Correspondent:

    With so much in the news about the subprime mortgage crisis, foreclosures and even threats to the global financial system, people are asking one simple question, among many: How could so much money the world over have financed such seemingly lousy loans?

    There are lots of reasons, of course. But the one we'll focus on, with the help of some low-rent toys from around the house, is a technique without which the globalization of the subprime housing boom would probably have been impossible. It's called securitization. We'll explain it in a bit, but first a reminder of how home lending used to work.

    A buyer bought a house by putting down maybe 20 percent of the price, borrowing the rest of the money from a bank, which had taken in the money as deposits mainly from people in the local area. The bank took a cut by charging the borrower a little more in interest than it paid the depositors. This is the system whose virtues Jimmy Stewart so classically extolled to his Bedford Falls bank depositors in "It's a Wonderful Life."


    Your money is in Joe's house. That's right next to yours, and in the Kennedy house and Mrs. Macklin's house and a hundred others. You're lending them the money to build, and then they're going to pay it back to you as best they can.


    With Stewart's bank in between.


    How much do you need?


    And that's pretty much how it was right up through the savings and loan crisis of the late '80s, the last time we used Jimmy Stewart on the NewsHour to explain the way banking used to be.

    So what was new this time around? Well, with the end of communism, the globalization of China, India, and the like, continuing prosperity in the U.S. and Europe, there was way more wealth in the world to be invested. Why not lend some of it for mortgages in the United States, where housing is the collateral, continually rising in price, and the interest rates are pretty high? But you don't do that through Jimmy Stewart's bank.

    Instead of banks like the Bailey Building and Loan, the main way to get money from lenders to borrowers has become securitization. To help us explain it, Wellesley economist Karl Case.

    Securitization, what's that?

    KARL CASE, Professor of Economics, Wellesley College: It used to be that when you signed a mortgage and borrowed money, the bank put the paper in its vault and held it. Now, almost all mortgages are sold in the secondary market. Wall Street firms package these mortgages up and then issue what are called mortgage-backed securities against them.