We all are familiar with the word of sub-prime crisis, for instance few months back , when I was pursuing my masters , and there was placements going on , the only topic used to be discussed was global downfall, due to sub-prime crisis. But when it was asked “what are sub-prime crisis, very few had an answer, and I wasn’t among the few. Even if you search on Google you won’t get many results. So let me try and explain what this sub prime crisis is?
In simple words sub prime crisis are associated with demand and supply of houses. Housing prices started gaining upward momentum in US in early years of this decade and continued through mid 2006, with the borrowing and lending rates extremely low, which elevated the demand for and supply of new existing houses.
Result of this demand and supply was creation of sub-prime lending industry by banks.
Sub prime lending refers to lending (at higher interest rates) to people, who may not be eligible for loan in normal circumstances. May be they don’t have job or income or defaulted in the past. It means many institutions offered home loans to borrowers with poor or no credit histories, requiring higher than normal repayment levels- creating now what is known as sub prime mortgages. Banks traditionally did not lend to such people due to high risk of default. But since these loans were mortgaged against property and property prices were rising continuously, banks started doing so. If customers defaulted, they good sell the mortgaged property.
However happy days started to end when on June 30th 2004, when Federal Reserve started with interest rates hikes that raised the cost of borrowing from the lowest levels registered since 1950’s. It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.25 per cent. The US housing market began sliding in August 2005 and that continued through 2006. Building rates and housing prices tumbled.
The excess liquidity slowly started to evaporate. It turned into creator of problems for Americans, informs of job losses, less consumer spending and fears of slowdown if not recession. A similar situation may develop in the UK, where housing prices during last five years have risen very rapidly, creating a wealth effect just as in the US. But prices there have now started correcting. This has a contagion effect and we may see a huge write-off by banks doing business in the US and the UK.
In US more than 25 sub-prime lenders declare bankruptcy, announce significant losses or put themselves for sale.
Turmoil in India
Given the dominance of US financial markets in other developed and developing economies, the sub prime crisis affected markets and institutions all over the globe.
The Indian economy showed signs of over-heating in mid -2007, with inflation rising above 6%.
The main channels through which global credit crunch and a recession in US can affect India are:
· A decline in capital inflows and lower corporate access to credit in international markets.
· Slowdown in export of goods and services from India to the US.
· remittances
India is running a current account deficit (CAD) which is likely to increase to 2.6% of GDP in 2009 from the 1.5% in 2008, driven largely by the sharp increase in international prices of oil and food commodities. So far India’s CAD has been comfortably financed through capital inflows and FDI. In this scenario, the question whether a global credit crunch and significant slowdown in the US economy could undermine India’s growth prospects, becomes pertinent.
Recent financial tsunami
September 2008: 9/15 will now be recognized as black Monday in history of financial system with Lehman Brothers file for bankruptcy. Merrill Lynch sells off to Bank of America.
In simple terms it means that the mortgage banks borrowed money against the mortgages on the condition that they would repay to lenders as soon as they recovered their mortgages. The lenders in this case were financial institutions (like Bear Sterns, Lehman and Merrill Lynch) who in turn sold retail bonds to individuals.
Sadly, the repayment never happened. And institutions like Bear Sterns, Lehman, Merrill Lynch and AIG were the casualties. Since the mortgages were not honored, the banks could not repay these financial institutions who in turn could not repay retail investors.
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