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Sub-prime Crisis: What is it all about? Research Team | Posted On Thursday, October 16,2008, 02:33 AM

Sub-prime Crisis: What is it all about?



Sub-prime crisis is the current financial crisis (considered as the worst ever since World War II) characterized by acute credit crunch in the global capital markets. This liquidity crunch is not only because of shortage of funds or higher interest rates but also because of mistrust among banks that have forced banks to stop lending to each other. Banks do not know whether other banks have enough cash and liquidity to survive to pay back the loan; thus, affecting the critical inter-banking operation in the economy. This has affected the liquidity in the market and made highly leveraged banks difficult to operate and survive.

Inter-Banking market operation
Open market operations is a tool used by Fed (RBI’s equivalent in the US) to regulate money supply in the economy. U.S. banks and thrift institutions are obligated by law to maintain certain level of reserves, which is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank\'s demand accounts.

For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and reduces the bank\'s reserves. If its reserve level falls below the legally required minimum, it must add to its reserves to remain compliant with the regulation. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. Thus, this operation is an extremely powerful tool not only to regulate liquidity in the economy but also for the survival of these banks.

Now imagine what will happen if banks stop lending to each other. Banks will not be able to match their assets and liabilities by borrowing from banks having surplus. Thus banks that have high liabilities or are highly leveraged (e.g. Lehman, Wachovia and Washington Mutual) will go bust!

Sub-prime home loan
Let me explain what does sub-prime loans mean. Prime home loans market refers to individuals with very good or excellent credit records or ratings and to whom banks lend directly. Sub-prime market refers to individuals, who have poor credit record characterized by unstable income. Thus, banks or other lending institutions would not lend money to such individuals. So, how will such individuals get home loans to fulfill their great American dreams? Here enters- financial institutions (FIs), which have excellent creditworthiness. These FIs take loan from banks at lower interest rates and break these loans into a lot of small home loans and lend them to “sub-prime” lenders at much higher interest rates. Thus, FIs make profits on the spread (difference between the lending and borrowing interest rates) by taking higher risks. This home loan market is called “Sub-prime home loan market”.

How this crisis started?
Many believe that sub-prime crisis is direct fallout of the US credit culture. i.e. borrow as much as possible way beyond the means. In 2008 the average household debt was 130% of the average income and average household owned 12 to 13 credit cards. Mind blowing! Isn’t it? The problem primarily began with the US 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 encouraged buyers to take on bigger loans, and thus bigger and better homes. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%. This was fostered by federal government to increase ownership among minorities and poor.

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 great 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 poor credit records. Few controls were put in place to handle the situation in case the housing bubble\' burst.

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. The sub-prime loans were given by FIs at floating rates. With rising interest rates in the US, EMIs for these individuals also started increasing (what we see today in Indian market) and 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 realized 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.

Why Investment Banks like Lehman Brothers went bust?
Earlier I talked about how FIs like Investment Banks made profits on the spread (difference between the lending and borrowing interest rates) by taking high risks on the money borrowed. This provided huge incentive to these FIs to borrow and lend as much as possible creating huge “leverage” on the books. During the time of housing boom, this was considered as MBS portfolios typically received high credit ratings with minimal defaults. Since Investment Banks do not have the same capital reserve requirement as Depository Banks, they borrowed and lent amounts exceeding 30 to 50 times their net worth i.e. their leverage on the books were between 30 to 50 compared to depository banks’ leverage of less than 15.

Now, housing market started declining by the end of 2005 and went bust in 2007. This along with increasing delinquencies and foreclosures by worried customers led to the decline of housing prices and in turn the value of MBS. Investors became concerned and in some cases demanded their money bank, resulting in margin calls (immediate need to sell the MBS portfolios at fire-sale prices) to pay them. At such high leverage (between 30 and 50), many FIs suffered huge losses, bankruptcy and merger with other banks. With this, MBS portfolios became extremely risky and hence “untouchable” and banks stopped buying or trading them. Their values plummeted further and all those institutions who have bought them suffered huge losses and created panic and acute liquidity concern in the market across the globe. Lehman Brothers had a leverage of 31 and hence went bust because it didn’t have enough cash to service margin calls by its creditors.

Effect on the economy
This severe liquidity crunch led to several negative effects on the economy. This ripple effect was seen not only in the US but also in the European Union because all these rich and big banks in the US and Europe invested heavily in these Mortgage Backed Securities (MBS) during the boom time. Banks stopped or became extremely reluctant to lend money to companies which have to either delay or stop their investment plans.

This has led to increase in unemployment and drop in the consumption. The financial crisis as we know caused a panic in the market and stock market declined heavily. Most of the US people have their investments either in real estate or stocks. As both these investment tools suffered heavy losses, average household value/income decreased sharply causing panic among citizens. In the coming years we might see major world economies such as US and Europe in recession.

Why India market fell?
Once investments by the FIs in the US turned bad, more money had to be invested back, to maintain that fixed proportion i.e. to match assets and liabilities on their books. 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 US, they went out to sell their investments in emerging markets like India where their investments have been doing well.

So they started selling their investments in India and other markets around the world to maintain enough liquidity in the US economy and for their own operation. Since the amount of selling in the market was much higher than the amount of buying, the Sensex began to tumble. Additionally, crude prices were in the range of $120-150 which caused inflation to rise in double digit forcing banks to raise their interest rates. Thus, higher rates seriously affected real estate, automobile and banking firms’ operations and their stock crashed. Moreover, there were some rumors that even Indians banks had some exposure to these risky MBS and hence, banking stocks were among the worst hits. The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar. The stock market will continue to tumble as long as there is huge selling pressure from these FIs.

This crisis is now 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 and underlying assets value is hundreds of trillions of dollars.

This is a total systematic failure which needed an urgent and high level attention across the world. Thus, we saw a $3 Trillion bail-out from central banks in the US and EU. Let’s keep our fingers crossed and see what future holds for us!

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