Credit Crunch Keywords
What is subprime mortgage?
A mortgage given to a home-buyer with less than sufficient credit, or who lacks a proven income source to support loan payments. Lenders with excess money in the U.S. were giving loans to almost anyone who asked - charging a little more interest in return for the riskier loans. The lenders made their bet on (U.S.) house prices to rise. Well, that’s not exactly what ended up happening. When housing prices began to fall, and interest rates started to rise, many borrowers wound up in trouble - causing to default on their loans.
How did the problem spread to Canada, and the rest of the financial world?
Many of the lenders (American Home Mortgage, HSBC, …) were selling the loans to other parties, including hedge funds and pension funds - who were also looking for higher returns. The subprime loans were bundled and sold to third-party investors. As the loans started to go bad (and default), people all across the financial world were affected. As others were affected, concerns over losses started to grow. The concerns causes investors and lenders to ask for higher rates, or stopped activities completely - the concept of the credit crunch.
What is commercial paper?
Commercial paper is short-term debt (with maturity dates less than a year) issued by companies. Institutional investors - money-market mutual funds, low-returning funds, etc. - tend to be the largest buyers of the market. As a result, only highly rated companies with strong balance sheets can generally issue commercial paper, limiting the size of the market.
What is asset-backed commercial paper?
Asset-backed commercial paper is exactly what it sounds like. Commercial paper, backed by assets such as car loans, mortgages and credit-card receivables. Which companies are involved? Trusts and other financial companies; the one’s you’ve probably heard on the news - Conventree Capital, National Bank of Canada, and so on.
So what’s the problem in the commercial paper market?
As concerns about the housing market bubble about to burst grows, portfolio managers at money-market mutual funds are doubting the investment in asset-backed commercial paper - especially those backed by assets such as mortgage loans. In consequence, this leaves the trusts short of cash, because no one is willing to buy their paper. Other banks are providing loans, and central banks are helping to provide liquidity.
What about my money-market mutual fund?
If your money-market mutual fund has invested in a trust that’s in trouble, it could spell out losses for the fund, and ultimately you - the investor.
Reminder: this is only a small portion of the market that’s in trouble, and not every money-market mutual fund holds paper issued by the trusts in trouble.
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