Sub-prime crisis simplified!

The sub-prime crisis in US has been the buzz word in media from past few months. Lot of my friends started asking what this is all about and here is the simplified version of the entire episode.

First thing you have to do is, forget about the terminology used in many news articles which will only confuse you.
The story goes like this…
In US of A there is something called as credit score for a person which is basically calculated from the past records of a person’s credit files, simply put the score tells us how well a person is able to pay his debts in time and can banks trust him to give a loan.
A person having a bad credit score is not eligible even for availing banking services, forget about getting a loan. So such people with low credit scores if borrows from a bank are called Sub-prime borrowers.

The last two lines above are contradicting each other. The question arises why would bank give loans to such people with low credit scores? The answer is simple, since there is a risk involved in giving loan to such people; banks charge higher interest and make higher returns. Now comes the interesting part, the boom of lending money to sub-prime borrowers. There were many investors who are willing to lend cash but the traditional borrowers are not having a need of cash. So investors had to look for new markets to invest in.

Seeing this opportunity, the banks gave money to sub-prime borrowers as mortgage loans (mortgage loans means taking loan on a property owned, if the loan is not repaid then the property will be taken by bank) and then these loans were bundled and derivative instruments called Collateralized Debt Obligations (CDOs) (one form of Asset Backed Securities) were issued. Investors bought these securities and thus indirectly provided the money required for sub-prime lending. Well, to put it simple, if the borrowers pay the interest on the loan regularly both banks and these investors who bought CDOs will profit. Lot of multinational banks and investment banks have bought these CDOs.

The sub-prime crisis occurred when these sub-prime borrowers defaulted (unable to pay) in their mortgage loans. This affected the returns on CDOs. On top of this the banks have issued home equity loans through which these borrowers could take second loan on the same mortgage. These added to their (borrowers) inability to payback the money. Lot of borrowers said they can’t pay back the loan and others have started panic selling of their properties due to which the prices have come down drastically. So other borrowers who thought of selling their properties to pay back loan were affected because the property prices have gone down. More and more people defaulted.

The CDOs were not performing well because of borrowers defaulting, so all the investors want their money back so they started selling these securities, forced selling of these securities reduced the price of these securities drastically. Investors who are holding these securities incurred huge losses. The concept is simple, as an investor I have bought something (CDOs) for 1 crore (say) today its value is 1 lakh, I am in huge loss, and I have to reflect this loss in my accounts. This was the main reason why many investment banks have filed for bankruptcy and why Bear Stearns was acquired by J P Morgan Chase for such a low price and why UBS or ICICI have declared huge losses in their accounts.

How Indian Stock market was affected?

The foreign investors who are having CDOs and who also invested in Indian stocks sold their stocks. The selling pressure melted down the stock markets; IT companies lost few of their clients who belong to US mortgage industry. Not only Indian markets, many other markets were affected across the globe in a similar fashion.

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4 Responses

  1. wow really nice explanation! thanks!

  2. nice writeup!

    You might also find my blog post http://bkpavan.wordpress.com/2008/07/15/subprime-primer/ informative

  3. cool inf dude…. 🙂

  4. Good article. Apart from the fact that banks based in other parts of the world also suffered losses from the subprime market, there are two major ways in which the effect is felt across the globe. First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities.Thus, any crisis in the US has a direct bearing on other countries, particularly those with large reserves like Japan, China and – to a lesser extent – India. Sub-prime ciris – A simple primer.

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