Sub Prime Crisis - An Understanding

Typically, loan (or mortgage) are divided into two classes named Prime and Sub-Prime (actually there is a third class which is in between prime and sub-prime. but lets not consider that for the sake of simplicity.) Now, Prime borrowers are those who have good credit history and Sub-prime borrowers are those who have bad credit history. By good credit history, we mean that people or institutions who pay their dues back. And bad credit history means that the loans taken were not paid either on time or not at all or more importantly they don't have an underlying asset to back up their loans or mortgages. Be it credit card payments, mortgages on houses, personal loans or money borrowed by the institutes or companies.


Now the actual sub-prime crisis started 5 years ago with the housing loans. When in US house/real estate prices were rising everyday and people thought that owning a house or property was the best investment. So people wanted to borrow money to invest in property. Now Banks knew that its risky to lend money to sub-prime borrowers, so they invented a new strategy to still lend money to these people which is very ticky.

They lended money to sub prime borrowers anyway, with little interest rates and advertisements like, less paper work or loans approved in 24 hrs, no down payment, no proof etc. Then they combined hundreds of these mortgages into a single financial instrument called CDO (Collateralized Debt Obligation). Then they divided these CDO into different classes of investments. Think of them as bonds with different credit ratings ranging from AAA to BBB. Then finally they sold these investments to other financial institutes and hedge funds for money with a promise that they will buy these investments back. Its just like Mutual Funds, you buy units of a MF and when it appreciates, you sell it back. Till you hold it, all the risk and reward will be yours.

Now since these hedge funds saw a AAA rating on these CDOs, they started to pour in money and bought heavily. They bought the risk too. This was not a bad strategy after all.

What went wrong is that the interest rates started climbing. Fed started increasing rates from 1% to 5.25%. Now the original borrowers couldn't pay back the loans as their EMIs increased by 30-60%. They raised their hands. The banks seized their houses. The CDOs took a hit, and ultimately those hedge funds suffered the losses. Just like you bought a MF unit at Rs 100 and now its value is just Rs. 20.

After Math of Crisis and Effect on Economy:

There is a huge supply of houses and no demand, realty sector took a hit. People who bought the houses at high value, now have homes at 30% less valuation. They feel poorer. They don't have the capacity or don't want to spend more because of this feeling. There is less spending power by people and institutes. So it gives rise to recession. On the other side, those hedge funds either became bankrupt or they started to sell off their investments to raise money for survival. These investments were in Stock markets all over the world. So Global markets took a hit. The sub prime write offs are estimated to be of the order of 500 billion dollars!!!

Some facts about the losses:

HSBC - $10.6 billion (as of February 2007)
Merrill Lynch - $7.9 billion
Citigroup - $3.2 billion
JPMorgan - $1.7 billion
Goldman Sachs - $1.5 billion
Bank of America - $1.4 billion
Wachovia - $1.3 billion
Morgan Stanley - $940 million
Lehman - $700 million
Bear Sterns - $700 million

Lesson:

Don't borrow money just because someone promises its easy. Don't borrow money if you cant repay it back. Don't borrow money if you don't have assets to back it up.

Hope you understood the whole mess. Send me your doubts at raunaqjainblog@gmail.com

Cheers!
Raunaq