Saturday, October 11, 2008

Subprime Mortgage Crisis



The Subprime Mortgage Crisis is an ongoing economic problem that has become more apparent in 2008 and has resulted in reduced liquidity in the global credit market and also the banking & financial systems. This crisis has exposed the weakness in the global financial system and also the regulatory framework that is overlooking them.

Some of the reasons for this crisis are:

1. The US Real estate market crash

2. High default rates on Subprime loans &

3. Subprime Mortgage backed securities

A Subprime loan is a loan that is granted to a borrower who does not qualify for loans owing to a variety of risk factors like low income level, bad credit history etc. For more details on Subprime loans refer to: SubPrime Loans

How it all started:

In the past few years, due to high liquidity and low interest rates on mortgage loans, the demand for housing properties started increasing. After the advent of the subprime lending practices, people who were, not so creditworthy began to buy homes using these loans. This resulted in a heavy demand for houses which in turn fuelled the increase in residential property prices. The prices increased exponentially and people who already owned homes, opted for refinance at lower interest rates.

At the same time, Banks were lending mortgage loans to everyone who asked for it, considering the property price hike. On one hand, they would get their money back even if the borrower doesn’t repay the loans and on the other hand the banks were selling their loan products to investment companies who packaged them into MBS and sold them in the open market. This resulted in the bank getting back almost their entire loan amount which they started lending to further subprime customers.

An MBS refers to Mortgage backed Securities. For more details on MBS refer to: MBS

What went wrong?

Trying to cash in on the heavy demand for residential properties, real estate majors started promoting a huge number of residential projects. This led to overbuilding. This resulted in a surplus inventory of homes which eventually caused the real estate prices to decline by the end of 2006.

Ease of availability of loans coupled with the assumption that property prices would continue to move upwards prompted a lot of subprime borrowers to buy houses. Once the housing prices started to fall, the interest rates on loans started to rise. Most of the borrowers were unable to make their payments on time and also due to unavailability of refinance options default on loans started to increase. For most home owners, their outstanding amount on the mortgage loan was much more than the value of their houses. This motivated home owners to walk away from their property in spite of the fact that it would impact their credit ratings. People were not ready to pay hefty mortgage amounts when their property wasn’t worth that much. If our home loan was worth 10 lacs and our home was worth only 6 lacs would we continue to pay our EMI on the home loan? :-)

This resulted in a surplus supply of houses which were available for Sale. The only way banks could reclaim their amount was by selling these homes. With the availability of so many homes, the prices of residential property fell further. The losses & Non Performing Asset’s for banks started to increase.

The high rate of default on subprime loans & downward movement of housing prices resulted in lower demands for the MBS products created out of subprime loans. The banks & financial institutions were unable to generate the liquidity that they were expecting to which resulted in an overall credit crunch. The Banks were left with too many houses with too little buyers and similary the financial institutions had lots of MBS products with very little takers.


The Billion Dollar Question:

Due to the subprime crisis, only banks should have received huge losses. Why have large financial institutions like Lehmann or Meryll Lynch have posted even bigger losses or even gone bankrupt?

The Answer: Once the banks finish lending subprime loans, the loan products would be bought by financial institutions and packed into MBS. These financial institutions are responsible for the money invested by investors on these securities. When the loans are defaulted, the payments received by the bank on them would dwindle, which would impact the payment to the investors in these MBS. Even if the bank does not make the payments, the financial institution which sold them has to incur losses and make the payments to the investors. The limit to which these institutions could manage was reached and one by one they started to fall.

What is the Impact?

1. Banks have incurred huge losses. Their earnings came down.
2. Financial institutions have gone bust or have been taken over by bigger organizations
3. The housing prices have plummeted
4. The liquidity in the financial system has come down etc.



Some other Questions:

1. When Banks were able to manage, why weren’t the financial institutions able to?
Banks receive customer deposits which they used to leverage their financial position and continue to operate whereas financial institutions do not receive any customer deposits. This is the reason why they were unable to survive under such dire circumstances.

2. Don’t banks know that lending to subprime borrowers is risky? Why did they still continue to do so?
The Banks do know that lending to subprime borrowers come with its inherent risks. They were confident of the US Real estate market and did not expect it to crash. Moreover the leverage provided by the MBS ensured a continuous supply of liquidity which they continued to lend to other borrowers.

3. We hear the names of even Insurance companies that are facing issues due to this crisis. What is the relationship of the insurance companies to this problem? How did they get impacted?
Some insurance providers have products that are intended to protect lending agencies against credit defaults in exchange for a premium or a fee. They are required to post a certain amount of collateral (either cash or any other highly liquid assets) to be in a position to provide payments in the event of loan defaults. This amount of capital is based upon the credit rating of the insurance company. Lower the credit rating greater is the amount that they need to place as collateral. Due to the financial crisis, the credit ratings of such insurance companies that provided credit default insurance products were brought down. Some of them were unable to manage that increase in capital which resulted in their downfall.

4. What happened to the investors who bought these MBS products?
The financial institutions were not able to repay everyone who bought those products from them. So they too incurred losses.

5. What is Next?
The US Federal Reserve and the US Government has announced a $700 billion bailout package using which the US Treasury department is going to purchase MBS units to infuse liquidity and stability into the market. The success of this scheme is very vital to stop the global economy from going down further...


Hope the explanation about sub prime crisis was clear... Happy Reading.

16 comments:

  1. Thanks for such explanation. it really helps me to increase my knowledge.i am realy searching such type of explanation regarding global financial crisis. i got it from ur explanation. thanks again.

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  2. i mst say ....nice explanation

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  3. Very well organised content; helps even a layman to unederstand!!

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  4. I want to know wheather these ongoing crisis have any correlation with the past crisis of 1980, 1998, 2002...?

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  5. Nice one.Well explained

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  6. A very nice explanation for a layman like me; highly recommended and appreciated; thanks a lot.

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  7. Very simple and nice explanation Anand. Thanks a lot for the info.

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  8. THANK YOU FOR EXPLAINING ALL THESE! YOU HELPED ME GREATLY FOR MY PROJECT!

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  9. toooooooooooooo gud!!:)

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  10. Hi Mr. Anand, your blog gave a very precise and comprehensive explanation about subprime crises.thank you so much as I am sure your efforts have helped a lot of them, like me, to understand this topic.

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