What is subprime crisis?

[B. Karthick]

The current upheaval in the global financial markets has caused more
mayhem in a fortnight than the world has seen in its entire economic
history.

Although there are many reasons responsible for bringing the world to
the doorstep of financial doom, the main cause of this financial
disaster is said to be the �sub-prime loan.'

So what is this sub-prime loan? And why has it caused global panic? If
it is related to the American housing sector, why should it affect
Indian and other markets?

A sub-prime loan

Sub-prime mortgage loans (or housing loans or junk loans) are very
risky. But since profits are high where the risk is high, a lot of
lenders get into this business to try and make a quick buck.

Sub-prime loans are dicey as they are given to people with unstable
incomes or low creditworthiness. These individuals are not financially
sound enough to be given a loan when judged under the strict standards
that should normally be followed by a bank or lending institution.

However, there's more to it. Let us simplify this issue to understand
better how sub-prime loans work and how they brought the world down to
its knees.

It all begins with an American wanting to live the famed American
dream.

So he seeks a housing loan to give shape to his dream home. But there
is a slight problem. He doesn't have good credit rating. This means
that he is unable to clear all the stringent conditions that a bank
imposes on an individual before it sanctions a loan.

Since his credit is not good enough, no bank will give him a home loan
as there is a fear that the chances of a default by him are high.
Banks don't like customers who default on their payments.

But lo!, before the American dream can fade away, there enters a
second American -- usually a robust financial institution -- who has
good credit rating and is willing to take on some amount of risk.

Given his good credit rating, the bank is willing to give the second
American a loan. The bank gives the loan at a certain rate of
interest.

The second American then divides this loan into a lot of small
portions and gives them out as home loans to lots of other Americans
-- like the first American -- who do not have a great credit rating
and to whom the bank would not have given a home loan in the first
place.

The second American gives out these loans at a rate of interest that
is much higher rate than the rate at which he borrowed money from the
bank. This higher rate is referred to as the sub-prime rate and this
home loan market is referred to as the sub-prime home loan market.

Also by giving out a home loan to lots of individuals, the second
American is trying to hedge his bets. He feels that even if a few of
his borrowers default, his overall position would not be affected
much, and he will end up making a neat profit.

Now if this home loan market is sub-prime, what is prime? The prime
home loan market refers to individuals who have good credit ratings
and to whom the banks lend directly.

Now let's get back to the sub-prime market. The institution giving out
loans in the sub-prime market does not stop here. It does not wait for
the principal and the interest on the sub-prime home loans to be
repaid, so that it can repay its loan to the bank (the prime lender),
which has given it the loan.


So what does the institution do?

It goes ahead and �securitises' these loans. Securitisation means
converting these home loans into financial securities, which promise
to pay a certain rate of interest. These financial securities are then
sold to big institutional investors.

Many investment banks (or institutions like the �second American' in
our story) sold complicated securities that were backed by debt which
was very risky.

And how are these investors repaid? The interest and the principal
that is repaid by the sub-prime borrowers through equated monthly
installments (EMIs) is passed onto these institutional investors.

The institution giving out the sub-prime loans takes the money that it
gets by selling the financial securities and passes it on to the bank
he had taken the loan from, thereby repaying the loan. And everybody
lives happily ever after. Or so it would have seemed.

The sub-prime home loans were given out as floating rate home loans. A
floating rate home loan as the name suggests is not fixed. As interest
rates go up, the interest rate on floating rate home loans also go up.
As interest rates to be paid on floating rate home loans go up, the
EMIs that need to be paid to service these loans go up as well.

With US interest rising, the EMIs too increased. Higher EMIs hit the
sub-prime borrowers hard. A lot of them in the first place had
unstable incomes and poor credit rating.

They, thus, defaulted. Once more and more sub-prime borrowers started
defaulting, payments to the institutional investors who had bought the
financial securities stopped, leading to huge losses.

The problem primarily began with the United States keeping its
interest rates very low for a very long time, thus encouraging
Americans to go in for housing loans, or mortgages. Lower interest
rates led to buyers wanting to take on bigger loans, and thus bigger
and better homes.

But life was fine. With the American economy doing well at that time
and housing prices soaring on the back of huge demand for real estate
and bigger and better homes, financial institutions saw a
mouthwatering opportunity in the mortgage market.

In their zeal to make a quick buck, these institutions relaxed the
strict regulatory procedures before extending housing loans to people
with unstable jobs and weak credit standing.

Few controls were put in place to handle the situation in case the
housing �bubble' burst. And when the US economy began to slow down,
the house of cards began to fall.

The crisis began with the bursting of the United States housing
bubble.

A slowing US economy, high interest rates, unrealistic real estate
prices, high inflation and rising oil tags together led to a fall in
stock markets, growth stagnation, job losses, lack of consumer
spending, a virtual halt to new jobs, and foreclosures and defaults.

Sub-prime homeowners began to default as they could no longer afford
to pay their EMIs. A deluge of such defaults inundated these
institutions and banks, wiping out their net worth. Their mortgage-
backed securities were almost worthless as real estate prices
crashed.

The moment it was found out that these institutions had failed to
manage the risk, panic spread. Investors realised that they could
hardly put any value on the securities that these institutions were
selling. This caused many a Wall Street pillar to crumble.

As defaults kept rising, these institutions could not service their
loans that they had taken from banks. So they turned to other
financial firms to help them out, but after a while these firms too
stopped extending credit realizing that the collateral backing this
credit would soon lose value in the falling real estate market.

Now burdened with tons of debt and no money to pay it back, the back
of these financial entities broke, leading to the current meltdown.

The problem worsened because institutions giving out sub-prime home
loans could easily securitise it. Once an institution securitises a
loan, it does not remain on the books of the institution.

Hence that institution does not take the risk of the loan going bad.
The risk is passed onto the investors who buy the financial securities
issued for securitising the home loan.

Another advantage of securitisation, which has now become a
disadvantage, is that money keeps coming in.

Once an institution securitises the first lot of home loans and repays
the bank it has borrowed from, it can borrow again to give out loans.
The bank having been repaid and made its money does not have any
inhibitions in lending out money again.

Given the fact that institutions giving out the loan did not take the
risk, their incentive was in just giving out the loan. Whether the
individual taking the home loan had the capacity to repay the loan or
not, wasn't their problem.

Thus proper due diligence to give out the home loan was not done and
loans were extended to individuals who are more likely to default.

Other than this, greater the amount of loan that the institution gave
out, greater was the amount it could securitise and, hence, greater
the amount of money it could earn.

After borrowers started defaulting, it came to light that institutions
giving out loans in the sub-prime market had been inflating the
incomes of borrowers, so that they could give out greater amount of
home loans.

By giving out greater amounts of home loan, they were able to
securitise more, issue more financial securities and earn more money.
Quite a vicious cycle, eh?

And so the story continued, till the day borrowers stop repaying.
Investors who bought the financial securities could be serviced.

Well, that still does not explain, why stock markets in India, fell?
Here's why. . .

Institutional investors who had invested in securitised paper from the
sub-prime home loan market in the US, saw their investments turning
into losses. Most big investors have a certain fixed proportion of
their total investments invested in various parts of the world. So...

Once investments in the US turned bad, more money had to be invested
in the US, to maintain that fixed proportion.

In order to invest more money in the US, money had to come in from
somewhere. To make up their losses in the sub-prime market in the
United States, they went out to sell their investments in emerging
markets like India where their investments have been doing well.

So these big institutional investors, to make good of their losses in
the sub-prime market, began to sell their investments in India and
other markets around the world. Since the amount of selling in the
market is much higher than the amount of buying, the Sensex began to
tumble.

The flight of capital from the Indian markets also led to a fall in
the value of the rupee against the US dollar.

Any other reason, apart from sub-prime crisis?

Of course! Sub-prime crisis alone could not have caused such mayhem,
although it is to blame for the beginning of the end.

This crisis is spreading from sub-prime to prime mortgages, home
equity loans, to commercial real estate, to unsecured consumer credit
(credit cards, student loans, auto loans), to leveraged loans that
financed reckless debt-laden leveraged buy outs, to municipal bonds,
to industrial and commercial loans, to corporate bonds, to the
derivative markets whose risk are indeterminate, etc.

It has been a total systemic failure that has its roots in the US real
estate and the sub-prime loan market.

Note: Some analysts say that the worst might not be over. . .