“What worries me most about the present credit crunch is that if one of my cheque is returned stamped “insufficient funds”, I won’t know whether that refers to mine or the bank’s” – Anonymous
This is what the subprime crisis which has its roots in the US real estate and which is causing a world wide financial ripple is all about.
It all starts with a bank loan
Suppose a person wants to buy a house. But he hasn’t got enough money for that. What can he do?
Of course, he can go for a bank loan.
Now suppose, the person has a bad credit rating because he had not paid his earlier loans on time. Or suppose his income is unstable. In either of this case, the banks will not give him a housing loan.
How can he get a loan to buy a house? In India, probably he can go after some money lender who will lend him money at higher interest rates than the bank, and will not worry about his ability to pay back, as long as he keeps getting the interest.
Now you thought such a system does not exist in US? Then you are wrong. It does exist and is called the subprime market.
No good credit rating? Subprime lenders can help
What happens in US is that a financial institution, called the subprime lenders, which has a good credit rating will borrow big loans from banks. Banks will give loans to these subprime lenders because they have good credit rating and loan payback history. Now these subprime lenders will use this money to give loans to those who are unable to get loans directly from the banks, except that these subprime loans will be at a higher rate of interest than that of banks.
So the loans which a person or an institution directly gets from a bank is called a prime loan. And a loan which is given using the money of a prime loan is called a subprime loan.
If the subprime lenders give loans at a higher interest rate to those who have bad credit rating or unstable income, then how assured is the repayment? Because bad credit rating means repayment risks, right? which is why banks refused to give loans to the subprime borrowers.
Well, these subprime lenders DO NOT wait for the subprime borrower to pay back all the monthly installments. Instead what they did was to securitize these loans, which is nothing but selling its loans to much bigger institutional investors. How does it work?
Subprime lenders sell loans to institutional investors
Suppose a subprime lender has given 100 loans to subprime (risky) borrowers. Now what it does is, it sells of those loans to bigger investors for an immediate profit. What the investors gain by buying this is receiving their money back in installments at a very higher interest rate than that would be offered to them anywhere else including in the banks or in corporate bonds.
So both, the subprime lender as well as the investor gain here because the lender will get rid of the risky loans that he has given and will make a quick profit by selling those loans to the institutional investors. And these investors gain because they would be receiving higher interest for the money they invested because subprime loans are at higher interest rates.
Now don’t the institutional investors know that the loans which they purchased from the subprime lenders are risky? Well, they know it, but they are assured because those loans are backed by financial securities, i.e the assets which comprise the loan which is the real estate/houses. Remember these were the days when there was a real estate boom in US and real estate prices were skyrocketing, and the economy was booming.
Then the subprime lenders having got back their loan amount by selling the loans to financial institutions will immediately repay the prime loan which they had borrowed from the banks. This will increase their credit rating with the banks for making before hand payments. And then the subprime lenders will borrow fresh loans from the banks to lend as subprime loans. And the cycle repeats once again.
Unpaid Subprime loans cause Subprime Crisis
Now that the subprime business has turned into a subprime crisis, what went wrong? Well obviously something was not right here. The economic basics. And that is what went wrong.
The subprime lenders being not responsible for the loans, since they used to sell it off to the bigger institutional investors, used to overstate the income of the borrowers when acquiring financial securities to the loans. Also, the subprime interest rates were floating interest rates, which meant all went fine as long as the economy was booming. But when there was a slowdown in the economy the floating rates skyrocketed and the subprime borrowers were unable to pay their installments and hence defaulted on their loans. Added to this was the fall in US real estate values. This meant that the assets which back the home loan securities had lost their value, further increasing the losses of the large institutional investors.
Simply put all those big institutional investors who had invested in buying subprime loans from subprime lenders simply collapsed when thousands of subprime borrowers defaulted on their loans.
Now why did this subprime crisis affect rest of the world, say countries like India? Because the large institutional investors had also invested money in emerging markets like India. And when they lost money in the US market, to make up for that loss they withdrew their invested money from rest of the world markets too. Thus, the US subprime crisis has caused a ripple effect across the globe.
And the story continues…