The Subprime Crisis

Prelude

In these trying times, one wonders where to spend to ensure profits in the short run and windfall profits in the long run. An average investor expects too much from his instruments. Contrary to the recessionary trend in the markets, its more about the psychological dent in the common man’s confidence that has prolonged the recovery. The falling of financial behemoths like a pack of cards was really a factor. It was of no help that automobile industries faced the music during the same time and oil prices see-sawed like a child’s play. These unwelcomed happenings encouraged the world wide speculations that recession has arrived and is here to stay.

Moving to the US and its perceptible role in giving birth to this crisis, arouses reflection of the past policies safeguarded by the Federal Reserve Bank. The chairman of the 80s, Alan Greenspan viewed spending as an indication of economy’s growth. He was of the view that one should save minimally since the government was taking care of the emergencies and nearly every expensive commodity was insured. He lowered the interest rates to assist the liquidity. Soon people began to realize their ambitions. The complex human nature can not be satiated. They began to spend multiple times of their income. The Housing bubble was a product of this tendency.

People, blinded by their ambitions baited onto the mortgage fish. The banks, on the other end, had already started trading the mortgage securities to investment banks like Lehman Brothers. Banks were pressurized from the top to increase their network of mortgage lending. Under a propensity to feed the cycle (will discuss later), they relaxed the criteria of granting the principal. Thus, the mortgages were sold out to all and sundry. It wasn’t imperative that customers did not have adequate bank balance, the collateral was deemed enough. Lending to such customers is known as Sub-prime lending.

How it worked out ?

Interest rates were further lowered to arrest the economy from receding into recession after the 2000 dot com bubble burst. Thus the money was flowing and people were willing to take loans. Situation was grim for those with bad credit records. They were not allotted the loans by the banks until then. Banks initiated another route for them. They started providing home loans to them at high interest rates, taking their homes as collateral. Since the property prices were rising uninhibitedly, banks assumed they will get good deals even if the sub- prime debtors were unable to pay the EMIs. The loans were offered in variety of formats. Most common of them was Adjustable Rate Mortgage, where the rate of interest could be increased depending on the economic trends. Debtors low on credibility, were undeterred. They were thinking of refinancing the loan at lower rate of interests when their property price would boom.

The situation does not end here. Banks realized they had taken too many risks. They had loan out ample money but were bound to oblige the bank account holders. To generate the money inflow, they decided to diversify the risk of sub-prime mortgage lending. The loans were divided into packages and securitized as Collaterized Debt Obligations to investment banks and other investors. Packages were accorded credit ratings like A, AA, AAA based on the relative credit records of the borrowers. As per the risk evaluation, CDOs were valued differently. Banks also approached insurers to get the sub-prime loan products insured. In case of defaults, the insurance agency could keep the collateral.

The investment banks created Credit Default Swaps (CDS) from these packages and sold it to other investors worldwide. CDS is a swap contract where investors make a series of payments for a particular loan derivative product and are paid off in case debtor defaults on loan linked to that CDS. Insurance companies too fell in for CDS and traded the derivatives vehemently. Going by the rising realty prices, they would have profited even in case of defaults.

The beginning of the end

These series of steps were really bringing in smiles to everybody’s face. The defaulters were few, but the overall situation was under control. A propensity was always there to continue this process. There was mounting pressure on the banks to offer more generous home loans to people and create more securitized instruments. Liquidity had decreased in the system considerably. A bout of inflation followed and there was whopping increase in rate of interest consequently. Customers were hard to find now. Many of the borrowers could not arrange the inflated EMIs. There was a substantial increase in the defaults. Insurers and investment bankers began to roll out money to pay the CDS investors. The condition worsened with a huge number of sub-prime borrowers refusing to pay EMIs and opting for foreclosures. Investment banks doled out huge sums as the part of their obligation to investors in CDS. In fact, they struggled to pay back and came in debts of billions of dollars.

The insurers were also feeling the heat. They tried to sell the collaterals. Few were willing to buy a property. The list of borrowers was longer than those of potential buyers. As a result, the realty prices plummeted and the insurers had to contend with selling at a subdued price. The result was same: billions of dollars in debt.

Banks which had propagated this crisis had many unsecuritized loans left with them. Moreover, the investors were approaching them to get their payment done. In spite of these facts they were in a relatively less cash-strapped position.

The impending crisis began to swallow one company after another. The widespread reach of the sub-prime related tradable components only aggravated the situation. Investors protested for their money which had disappeared. Investment banks had been cogitating filing bankruptcy. Insurance companies were aided by the government bailout packages. Onus was falling on the banks which initiated the toxic trading in the first place. Some acquisitions followed while some fell apart. Some of the companies went to their deathbed. The rest pleaded monetary assistance from the Federal Reserve and the US Govt.

An Epidemic ?

This crisis had percolated to the European and Asian markets. Many companies which had invested in the loan derivatives belonged to the same region. Individual investors were also left in the lurch. English banks suffered huge losses. They were acquired and saved by their better off peers. The vast after effects dented investors’ confidence. He/she had suffered losses or was lucky to survive the storm. For obvious reasons, it was imperative that every step is taken with caution. Thus came the bearish trend in markets. Investors were concerned about selling shares at some profit rather buying more and suffering from losses in future.

The share markets can regain their pre-crisis levels in times to come. It’s truly a matter of returning to safe measures and adequate regulations to ensure the proper functioning of financial sector in future.