How Subprime Financing Works

Banks like Merrill, Bear Stearns, Lehman Brothers and JPMorgan Chase have long been attracted to buying subprime loans from lenders because they can convert them into mortgage-backed securities and sell those bonds to hedge funds and other institutional investors. It’s been a profitable endeavor in the past few years for those companies that got into the market at the right time.

But with defaults on subprime mortgages rising rapidly, mortgage lenders have been pushed into bankruptcy. And big banks, like HSBC, that bought those now troubled loans found themselves putting aside massive amounts of money in provisions to cover defaults. HSBC set aside $10.6 billion in 2006, while New Century Financial reported its first quarterly loss since 2001 because of the deteriorating market.