Making sense of sub-prime

The sub-prime issue is one that has been in the forefront for anything that has to do with allocation of capital in the past few months. So what is sub-prime and why is it causing so much pain for people all round the world.? To understand more on this join me to for a trip to Blunderland. People of this country have been work hard for a living and are the envy of the rest of the world. Everyone wants to go there as life seems good there.
One summer the banks in Blunderville start to give out money to people in Blunderville to buy lemons with the condition that they need to pay it back over 30 yrs at a very low cost ( read rate of interest). The cost being low, many people start buying lemons. Seeing the sudden increase in the demand for lemons, the farmers start cultivating more and more but they are not able to keep up with the overwhelming demand for lemons. People holding lemons then decide that they are willing to let go of a few but of course at a much higher price than they bought it for. All the second hand buyers are happy to pay the price because they too can get the banks to pay the increased price. The prices of lemons in Blunderville keep increasing but it makes everyone richer and so everyone is happy. The bigger the lemon, the higher the price. Some people even pack the lemons in good looking wrappings and that increased the value of the lemon to much more than what it takes to wrap it. The people who do not have money to make the payments (read sub prime borrowers) are offered loans but are told that they would be able to make the payments because the value of lemons never go down.
After a while the banks decide that they could make the people even happier. Since the value of the lemons they hold have all gone up, why not let them borrow even more money. So for the increased value of lemons from the time when people bought them, banks give them more money. People at Blunderville are all extremely happy and then start buying things from the rest of the world.
The banks meanwhile decide that for them to let this happy situation to continue they need to sell the loans to others who may be interested in sharing the increased value in lemons. They issue a lemon certificate, the holder of which is entitled to get a share of the payment made by lemon holders for well into the future. These lemon certificates are bought by banks all around the world and they too decide that lemons indeed have tremendous value and so they do the same. The new lemon economy causes the prices of other assets such as shares and land to go up in value around the world but everyone is happy because everyone feels richer. Everyone puts money back into Blunderville to be a part of the rise of the lemons.
After a while the wealth generated by lemon holders are so large that the prices of everything in Blunderville go up and so the banks decide to increase the cost of money. The people holding very high value lemons and people who were making a small monthly payment everyday suddenly find that they are unable to find new buyers or unable to make payments. All the people are bewildered as to why the mere raising of cost of borrowing makes their lemons less valuable. With lesser number of buyers for lemons, some people start to reduce prices. The people with lemons now face the situation of having to repay the original amount taken to buy lemons, the extra money borrowed to match the perceived increase in value of lemons and not being able to find new buyers at a higher price. The price of lemons start falling continously and so some people decide it is not worth repaying the money to the banks, afterall they have very little of their own money in lemons. With no new buyers the lemons start to pile up and the prices keep coming down. People who had no money to pay for lemons initially find that the money they need to pay every month to the bank has gone up but they are not as inclined to pay now as they see lesser value in lemons. In the meanwhile, the holders of the lemon certificates start to get worried as they could not see the price of lemons falling or in some cases they did not even know that they were holding lemon certificates.
After a while everyone begin to realise that lemons arent that valuable after all. They blame each other for not realising this earlier. Banks and other lemon holders start selling other assets like shares to meet their obligations and thus causing the prices of other assets to come down too. Blunderville wants to keep the prices of lemons at their past highs by providing cheap money but then the rest of the world decides that they do not want to keep supporting the lemon economy.
In essence sub-prime is about thinking that by merely supplying people with cheap money to buy lemons (read houses) and then riding reckelessly on the false notion till the prices of the lemons bought with borrowed money went so high that no one wanted them. Sadly enough people are always in search on new lemons in Blunderville. As to whether the rest of the world will do their part to support Blunderville is yet to be seen.