Plague of US sub –prime crisis

Nowadays common topic of discussion among employees, students & all is subprime crisis, fall of Lehman brother, US economy & impact on India. I also had this question surrounded by my mind what exactly happened which led to such financial crisis in world’s strongest and powerful country.
I have seen many posts on this and from searching materials from various places, I have tried to explain, how this whole cycle of sub prime began and made whole world dancing on its tunes.

Let’s begin with
What are Sub Prime loans?
The sub-prime loans are loans which are given to borrowers with low credit scores. These are the loans which are granted at interest rates above the prime lending rate. These borrowers are subject to sub prime lending on their defaults in credit card payments or any other type of credit default or delays.
According to US standards these are people who have FICO score < 620.
Now you might be wondering what is this FICO score, what I get to know of this was:
A FICO score is a credit score developed by Fao Isaac & Co. credit scoring method of determining the likelihood that credit users will pay the bills.
Credit scores analyze a borrower’s credit history considering number of factors such as:
· Late payments
· The amount of time credit has been established.
· The amount of credit used Vs amount of credit available.
· Length of time at present residence.
· Nature of credit information such as bankrupts, charge offs etc.

There are 3 FICO scores to be computed by data provided by each of the 3 bureaus- explain, Trans union and Equifax. Some lenders use one of these 3 scores, while other lenders may use middle score.

How this sub –prime loans came into being?
If we rewind ourselves to period of 2000, it is to be noticed that after the tech bubble burst and fears of 9/11 attack in 2001 , federal reserve began to cut rates drastically and federal funds rate reached at 1% in 2003 , which in central banking idiom is essentially zero. The overall idea of federal behind these rates cut was to prevent economy going into depression and to increase money supply to encourage borrowing, which would spur investment and spending. This led to aggressive lending by banking and financial institutions. However there was a good proportion of demand was from sub prime borrowers, so naturally when banks lend to them, it was with the pleasing knowledge that interest rates would be higher for this class of loans.
Every individual aspires a dream of having his own house. Americans were no exception to this. These low interest rates and increased liquidity increased demand for housing, which led to continuous growth in the market value of these assets (i.e. Real Estate), which was the collateral for the debt. Another angle is that the average American is highly debt-oriented, and resultantly, refinance is fairly commonplace in the US. In order to capture the market, banks began to value these assets higher and higher, as a higher valuation meant a higher loan amount which could enable them to win a deal over competition. This higher valuation also had an impact on the real money-value of the asset.
What was the role of investment banks?
First let me here clarify here what is investment banking & how it is different from commercial banking:

Investment banking is a field of banking that aids companies in acquiring funds. In addition to the acquisition of new funds, investment banking also offers advice for a wide range of transactions a company might engage in. A majority of investment banks offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.

Now let’s see how this whole cycle worked:
Our story begins with an American, who like evrybody else has a dream to own a house. Now in order to fulfill his dream he seeks for a home loan. However his credit history is poor. But things become easy for this American with the advent of subprine loans (explained above).

· A subprime borrower (in our story American) takes a mortgage from institution like Well Fargo Home mortgage at 2/28 ARM terms.
· As soon as deal is signed these instructions package these mortgages into MBS (mortgage backed securities) and sell them off to other financial institutions like investment banks (Lehman brother, Morgan Stanley, etc).
· The banks then proceed to securitize these loans, chop them up, and package them into products called CDOs or Collateralized Debt Obligations which entitle the holders to the cash flows from the underlying mortgages.
· These CDOs are then sold to other market participants like hedge funds, pension funds, other banks and insurance companies based all over the world.
· The CDOs may then be traded like any financial security and thus ended up being held by banks and other market participants all over the world.

The question revolving in your mind now would be why financial institutions would buy loans of sub-prime borrowers here comes the role of rating agencies:
A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to different rating agencies. However the flip side is that it’s hard to sell a security if it’s not rated.

How this situation led to financial fiasco?
With the coming of these sub-prime loans for few years things went pretty well, as with low interest rates, economy started to surge upwards, with value of real estates assets touching the sky. This situation made it easy for borrowers to make payments, in case they did run into troubled waters they could top-up their loans, or re-finance their loans at more favorable terms. So this was kind of happy –go lucky times for financial institutions.
However as in case of every bollyood movies good times are snatched away by villains, something like this happened in US financial markets. The slowdown began in late 2006 and early 2007. With fast growing economy, money started to flow in to equities and money supply reduced. Following such a scenario FED started to increase interest rates. This situation made re-financing of loans by borrowers difficult. As loans became more expensive, the demand for housing reduced, leading to a reduction in the value of the asset. Now this led to a chaotic situation, where borrowers began to default on their loans at an alarming rate. The investing institutions who held the securities backed by this debt stood to loose.

These financial crises plagued like anything all over the economy. In this hue and cry banks stopped lending to each other. Most investment banks and hedge funds had to write down the value of their holdings or liquidate other investments to meet redemptions. With CDO prices at rock bottom levels, market players were forced to borrow heavily.

This led to a huge liquidity crunch in the global markets and subsequently runs on and the collapse of a few banks in Europe. With nobody ready to lend money, overnight rates in the money markets skyrocketed setting the stage for further runs on banks and even the freezing or possible collapse of the entire banking system.
Coming to Indian scenario, how all this is impacting India, will be covered in my next post……..till then enjoy reading!
References:
www.economictimes.com
www.investopedia.com
Financial blogs