The recent global market sell down left both investors and speculators reeling with fear and hope. With this clout of uncertainty, we aim to inform the educated investor some background on the US subprime mortgage issue, and hope that he can make his own educated decision from thence.

Housing prices in the states have been increasing these recent years. It is estimated that there are 6 million people with high credit risk who have borrowed the full value of their house during such a boom.

But of course banks are not so naïve to lend to people who most probably are unable to pay. Hence they will use two primary means to profit from this transaction.

1. Using these mortgages as collaterals

Banks will first set up a hedge fund. Then banks will pump money into these hedge funds who will buy up these mortgages as securities (here, known as Collateral Debt Obligations CDOs). And because housing prices have been going up, these hedge funds have no problems in increasing the intrinsic values of these mortgages. Now the hedge fund has CDO that shows a positive performance. Using this CDO, the hedge fund will borrow cash from another bank using this CDO as collateral. The cycle continues on.

The danger comes when the housing price starts to fall. When suddenly the banks wish to sell off their collaterals, they realize that they have never been sold off before in an open market, and hence might very well be much over valuated.

2. Getting an insurance for these credits

The other way of diffusing the risk of default is by a scheme known as CDS Credit Default Swap. CDSes are analogous to insurance packages, insuring against the possibility of default.

Supposing Bob wishes to borrow 1000 dollars from me, and promises he will return within a year. I am fully aware that Bob is most probably not able to pay up. However I lend Bob the money, and approach another friend, Sam. I tell Sam that I will pay him 10 dollars a month for the next year. In the event that Bob pays up, Sam gets to keep the 120 dollars. If Bob does not pay up, then Sam will have to bear the responsibility of the default. Hence, the risk of default is shifted to another party.

So what next?

The recent weeks have seen a massive sell down of the market. On Friday, the central banks have intervened to stabilize the entire market. In Singapore, public sentiments are mixed. There are a group of investors who chose to sail through the storm while others have chosen to stay at the sidelines, waiting for the storm to pass. Sailing through the storm will be very advantageous for you if the storm clears up soon. While the sideliners will be busy getting the crew back on deck, you will already be sailing and advancing fast. Staying on the sidelines albeit slow, would be a safer bet. Cause if the storm turns into a gale, at least you will still have you ship safely in the dock. The few points you lose to those who brave the storm is your “insurance premium” you chose to pay.