Sep 2008 Global Financial Market has experience worst economic crisis in its entire economic history.
Although there are many reasons responsible for bringing world to the doorstep of financial crisis, the main cause of this financial disaster is sub-prime loan.
So what is sub-prime loan? And why has it cause global panic? If it is related to US housing sector why it affected Indian and other global market?
Let first understand what is subprime loan?
Subprime loan is loan which is not prime loan
Now what is prime loan?
Prime loan is a loan where we follow all terms and condition without compromising in ant terms and condition specified by central bank like RBI in India
Prime loan sanctioned at prime lending rate.
Few example of Prime loan is
KPC compliance
Income Proof
Title ship clearance ect.
Hence a loan sanction with compromise with such terms and condition will called subprime loan.
Subprime loan is very risky but return is high. It simple more risk more rewards due to which in US many lenders has started this business to make quick money.
Now let understand how subprime affects US and globe?
It all started with American dream of sophisticated and luxurious living standard
Housing accommodation is first on that list.
So he started seeking housing loan to give shape of his dream, but there is one problem he don’t have good credit ratings hence he failed to get prime loan. Since his credit is not well enough no banks were ready to sanction his housing loan.
But before American dream fade away, another American enter in to the market they are known as financial institution, who has good credit rating and are ready to take some risk.
Hence they planned one new business opportunity, whit the help of good credit rating they get huge bank loan and then divided that loan amount in to small small peace, and gave that to many American as housing loan at much higher rate then what they have to pay to bank against of their loan.
These higher rates is called subprime rate. The loan by second American to first American is called Prime Loan. And this loan market is called subprime housing loan market.
Now what is Subprime Crises?
All financial institution who has lend subprime loan i.e. Second American, there were knowing that default ration will be high so they hedge their ex-poser, so that in case of default still they will get funded by hedge fund.
But second American doesn’t stop there; it doesn’t wait for principal and interest of subprime loans to be repaid, so that it can repay its prime loan to banks.
So what this financial institution does?
They went for securitization.
Securitization is a way of conversion of these in to financial security which either issued at discount or bears some interest.
During securitization following person come in the picture
Special purposes Vehicle
Credit rating Company
Hence in order to make quick money, much financial institution (Second American) issued this kind of securities which is highly risky.
And how investor of such security is gets paid – this is through the principal and interest received from borrower of subprime loan as a monthly installment.
Financial Institution repays its prime loan from banks from the money that it get by selling of those security to the investor and everyone live happy ever after, as it seems.
But its not like, all subprime loan sanctioned at floating rate, floating rate is a rate which is not fixed as interest rate go up floating rate will also go up. And as floating interest will go up monthly EMI of subprime loan will also go up.
In that time US interest rate has increase significantly due to which monthly EMI of subprime loan also increase. which hit subprime borrower hard.
As we know lot of them was with unstable income and with poor credit rating, thus they default.
Once more and more subprime borrower start defaulting payment to investor )who has purchase securitized security) has stopped resulting huge loss.
Problem start because US keep interest rate too low for very long time which encourage American to go for subprime housing loan to purchase bigger and better home.
As US economy was doing well that time, every day housing price touching new high due to huge demand.
The crisis began with the bursting of the United States housing bubble
Slow US economy, high interest rate, Unrealistic real state price, high inflation together led to fall stock market, negative growth rate, job loss, lock of liquidity, negative sentiment, halt in new jobs and default.
Due to above subprime borrower start defaulting since they was not able to repay such huge monthly EMI.
Due to this all financial institution was not getting return of their investment. Because the mortgage based security is almost worth less
The moment it was found that these financial institutions is failed to manage risk, panic spread. Investor found that they hardly able to get some money on security that these institution has sold to them. This cause many wall street’s pillar to crumble.
As the default kept rising these institution could not service loan (which they have taken from bank for issuing subprime loan). Hence they started asking for credit from other financial institution which also stops their support as assets value was keep decreasing day by day due to falling real estate market.
The problem worsen because these institution easily securities these security and once securities assets does not exist in balance sheet.
Hence institution does not take in to consideration of loan going bad. Because risk will immediately passed to investor who has purchase these security.
Another advantage of securitization is money comes immediately, means institution no need to wait for long time of EMI.
Because of this in a harry of making quick money once they finish with one cycle of they immediately another cycle of getting prime loan then distribution it in small piece of subprime loan and then securitization and repayment of these loan to bank. This time with much bigger amount, hence amount increased as they enter with each new cycle.
Given the fact that institutions giving out the loan did not take the risk, their incentive was in just giving out the loan. Whether the individual taking the home loan had the capacity to repay the loan or not, wasn't their problem.
Thus proper due diligence to give out the home loan was not done and loans were extended to individuals who are more likely to default.
After borrowers started defaulting, it came to light that institutions giving out loans in the sub-prime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans.
And so the story continued, till the day borrowers stop repaying. Investors who bought the financial securities could be serviced.
Although there are many reasons responsible for bringing world to the doorstep of financial crisis, the main cause of this financial disaster is sub-prime loan.
So what is sub-prime loan? And why has it cause global panic? If it is related to US housing sector why it affected Indian and other global market?
Let first understand what is subprime loan?
Subprime loan is loan which is not prime loan
Now what is prime loan?
Prime loan is a loan where we follow all terms and condition without compromising in ant terms and condition specified by central bank like RBI in India
Prime loan sanctioned at prime lending rate.
Few example of Prime loan is
KPC compliance
Income Proof
Title ship clearance ect.
Hence a loan sanction with compromise with such terms and condition will called subprime loan.
Subprime loan is very risky but return is high. It simple more risk more rewards due to which in US many lenders has started this business to make quick money.
Now let understand how subprime affects US and globe?
It all started with American dream of sophisticated and luxurious living standard
Housing accommodation is first on that list.
So he started seeking housing loan to give shape of his dream, but there is one problem he don’t have good credit ratings hence he failed to get prime loan. Since his credit is not well enough no banks were ready to sanction his housing loan.
But before American dream fade away, another American enter in to the market they are known as financial institution, who has good credit rating and are ready to take some risk.
Hence they planned one new business opportunity, whit the help of good credit rating they get huge bank loan and then divided that loan amount in to small small peace, and gave that to many American as housing loan at much higher rate then what they have to pay to bank against of their loan.
These higher rates is called subprime rate. The loan by second American to first American is called Prime Loan. And this loan market is called subprime housing loan market.
Now what is Subprime Crises?
All financial institution who has lend subprime loan i.e. Second American, there were knowing that default ration will be high so they hedge their ex-poser, so that in case of default still they will get funded by hedge fund.
But second American doesn’t stop there; it doesn’t wait for principal and interest of subprime loans to be repaid, so that it can repay its prime loan to banks.
So what this financial institution does?
They went for securitization.
Securitization is a way of conversion of these in to financial security which either issued at discount or bears some interest.
During securitization following person come in the picture
Special purposes Vehicle
Credit rating Company
Hence in order to make quick money, much financial institution (Second American) issued this kind of securities which is highly risky.
And how investor of such security is gets paid – this is through the principal and interest received from borrower of subprime loan as a monthly installment.
Financial Institution repays its prime loan from banks from the money that it get by selling of those security to the investor and everyone live happy ever after, as it seems.
But its not like, all subprime loan sanctioned at floating rate, floating rate is a rate which is not fixed as interest rate go up floating rate will also go up. And as floating interest will go up monthly EMI of subprime loan will also go up.
In that time US interest rate has increase significantly due to which monthly EMI of subprime loan also increase. which hit subprime borrower hard.
As we know lot of them was with unstable income and with poor credit rating, thus they default.
Once more and more subprime borrower start defaulting payment to investor )who has purchase securitized security) has stopped resulting huge loss.
Problem start because US keep interest rate too low for very long time which encourage American to go for subprime housing loan to purchase bigger and better home.
As US economy was doing well that time, every day housing price touching new high due to huge demand.
The crisis began with the bursting of the United States housing bubble
Slow US economy, high interest rate, Unrealistic real state price, high inflation together led to fall stock market, negative growth rate, job loss, lock of liquidity, negative sentiment, halt in new jobs and default.
Due to above subprime borrower start defaulting since they was not able to repay such huge monthly EMI.
Due to this all financial institution was not getting return of their investment. Because the mortgage based security is almost worth less
The moment it was found that these financial institutions is failed to manage risk, panic spread. Investor found that they hardly able to get some money on security that these institution has sold to them. This cause many wall street’s pillar to crumble.
As the default kept rising these institution could not service loan (which they have taken from bank for issuing subprime loan). Hence they started asking for credit from other financial institution which also stops their support as assets value was keep decreasing day by day due to falling real estate market.
The problem worsen because these institution easily securities these security and once securities assets does not exist in balance sheet.
Hence institution does not take in to consideration of loan going bad. Because risk will immediately passed to investor who has purchase these security.
Another advantage of securitization is money comes immediately, means institution no need to wait for long time of EMI.
Because of this in a harry of making quick money once they finish with one cycle of they immediately another cycle of getting prime loan then distribution it in small piece of subprime loan and then securitization and repayment of these loan to bank. This time with much bigger amount, hence amount increased as they enter with each new cycle.
Given the fact that institutions giving out the loan did not take the risk, their incentive was in just giving out the loan. Whether the individual taking the home loan had the capacity to repay the loan or not, wasn't their problem.
Thus proper due diligence to give out the home loan was not done and loans were extended to individuals who are more likely to default.
After borrowers started defaulting, it came to light that institutions giving out loans in the sub-prime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans.
And so the story continued, till the day borrowers stop repaying. Investors who bought the financial securities could be serviced.
Well, that still does not explain, why stock markets in India, fell? Here's why. . .
Institutional investors who had invested in securitised paper from the sub-prime home loan market in the US, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world. So
Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion.
In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the United States, they went out to sell their investments in emerging markets like India where their investments have been doing well.
So these big institutional investors, to make good of their losses in the sub-prime market, began to sell their investments in India and other markets around the world. Since the amount of selling in the market is much higher than the amount of buying, the Sensex began to tumble.
The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar.
So these big institutional investors, to make good of their losses in the sub-prime market, began to sell their investments in India and other markets around the world. Since the amount of selling in the market is much higher than the amount of buying, the Sensex began to tumble.
The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar.
Any other reason, apart from sub-prime crisis?
Of course! Sub-prime crisis alone could not have caused such mayhem, although it is to blame for the beginning of the end.
This crisis is spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate, etc.
Of course! Sub-prime crisis alone could not have caused such mayhem, although it is to blame for the beginning of the end.
This crisis is spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate, etc.
It has been a total systemic failure that has its roots in the US real estate and the sub-prime loan market.
No comments:
Post a Comment