The return of subprime bonds: Is Wall Street courting disaster?

Remember subprime mortgages? That's right, the loans that for several years were issued to homeowners with shaky credit, or "anyone essentially with a pulse," writes Jillian Berman at The Huffington Post. These mortgages were bundled into securities, and bought up en masse by Wall Street. In 2007 and 2008, when many borrowers began defaulting, it led to gargantuan losses at banks, and brought the financial system to the brink of extinction. And yet, suddenly these subprime bonds are again selling like hot cakes, sparking concerns that Wall Street is playing with fire. Here, a guide to the renewed appetite for risky bets:

Who is purchasing subprime bonds?

As before, banks and hedge funds are leading the charge. Goldman Sachs recently paid the Fed $6 billion for bonds that had been owned by AIG, the insurance giant that collapsed under the weight of its toxic assets. In January, Credit Suisse Group bought $7 billion in AIG-owned bonds from the Fed. Even some hedge funds that made billions betting against subprime bonds in 2007 are now whistling a different tune.

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What has changed?

After years of being spurned, subprime bonds are dirt-cheap, and could thus provide risk-taking buyers with healthy profits. Investors say the bargain-basement prices also protect them from adverse scenarios, such as a steep drop in home prices.

Could the subprime renaissance bode well for the economy?

Possibly. Subprime investors are betting that housing prices have finally stabilized. If they're right, the broader economy may improve, since it has been dragged down by the slumping housing market for years. Furthermore, a renewed interest in subprime bonds could open up mortgage lending to more borrowers, loosening up historically tight credit and giving a jolt to the economy.

Are there risks?

Definitely. In particular, subprime bonds could collapse in value if the European debt crisis worsens. European banks are exposed to the U.S. housing market, and a fire-sale of subprime bonds could cause chaos in the U.S. In addition, U.S. banks continue to lose money from the subprime bonds they bought before the crisis, a reminder that such bonds pose serious dangers to any firm's balance sheet. Beware, says Berman. "If history is any indication, a boost in investor appetite for these types of bonds may spell disaster."

Sources: Bloomberg, The Huffington Post, The New York Times, Time, The Wall Street Journal