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Subprime Mortgage Credit Derivatives by FRANK J. FABOZZI, THOMAS A. ZIMMERMAN, DOUGLAS J. LUCAS, SHUMIN LI, LAURIE S. GOODMAN

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CHAPTER 13

The Great Subprime Meltdown of 2007

This chapter provides a brief survey of the subprime mortgage market that existed in the United States from 2000 to 2007. It is a story of how a small, inconsequential part of the mortgage market grew into a monster large enough to shake the very foundations of the U.S. financial system. It is a story with some elements that are old (all bull markets share common traits) and some that are new (credit default swaps, mezzanine CDOs, ABX, etc.), and it is a story that is not over.

A “new” subprime industry is evolving from the ashes of the old, but its final shape is not yet known. We know that the industry that prevailed from 2000 to 2007 no longer exists. We do not know precisely what will take its place. It will be a much smaller industry; it will consist of largely portfolio-based lending by large financial institutions; and it will be mainly subprime loans that have few of the layered risk elements (explained here in detail) that came to dominate the industry in recent years. As of this writing (September 2007), the industry is struggling to find the right type of loan that borrowers can afford and still meet the new bank regulations. If and when subprime loans are securitized again, the new loans will also have to accommodate much tougher enhancement levels demanded by the rating agencies and be a product that investors will once again accept. Developing a product that meets all of those constraints will not be easy.

The subprime ...

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