Sub-prime Crisis

by Shweta Chopra Its very common to find people completely lost regarding very important economic occurrences that affect the entire global economy. The US sub-prime crisis of 2007 is one such example. Even students of economics dont know exactly what happened, or how it may have added to or led to the recession that followed. This is an attempt to make sure everyone, including people who have never even heard of terms like GDP, can understand how exactly this crisis unfolded. Lets start with basic definitions. Sub-prime lending refers to making loans that are in the riskiest category of consumer loans. We measure risk by the probability of defaulting. People who borrow money from banks 'default' by not paying back their loans. Now you may wonder why a bank would lend to a consumer who is likely to not pay back the loan. Theres a little background to that. Before the crisis, the supply of money with US banks had increased due to various reasons, ranging from the boom in high-saving, developing nations like China and India to the wealth generated by the technology boom. Now the banks had to lend this money to earn profit on it (banks charge interest on loans over and above the principal amount, and so generate profits just by the act of lending out money). In order to make this happen, lending standards fell. Lending standards refer to the required standards of credit history of the borrower, to ensure that the loan will not be defaulted upon. A good credit history can be directly attributed to making payments on time, less revolving credit on credit cards, fewer payment defaults and check bounces, etc. With a poor credit history, the risk of default on loans increases greatly. Lending mortgage loans to such people is called sub-prime lending. Consequently, US banks charged a higher rate of interest, to make up for the risk they were taking. From the banks side, a higher interest means a higher return, despite the risk. As a result, some banks saw lending money to sub-prime borrowers as an opportunity, not a risk. The sub-prime borrowers, on the other hand, were counting on the housing boom to pay back their loans. The almost universal opinion at the time was that housing prices always go up. So they put their money in property, expecting to gain from property appreciation. To further reduce their risk, and make more profits, banks repackaged these mortgages as investment products and sold them to financial institutions the world over. Many of the bad mortgages were grouped together with good mortgages and sold as a single investment called Collateralized Debt Obligations (CDOs). The value of these investment products was directly linked to the performance of the package of mortgage loans. Now people arent stupid, and would not purchase these investment securities knowing that they have a considerable chance of failure. Credit rating agencies have the job of rating these securities on the basis of the riskiness to the borrower (the ones who took the mortgage loans), with risky borrower-based investments getting a low rating. After the crisis, its apparent that credit rating agencies were paid to put artificially high ratings on these investments to make them appear safer and make them easier to sell. This entire chain of transactions to earn profits was based on the crucial assumption that the assets backing such investments, like houses, would not only maintain, but increase their value. That is why at the beginning of the chain, banks were willing to lend money to an otherwise dubious group of customers known as NINJAs (No Income, No Job or Assets). The basic assumption was that even if borrowers defaulted, the bank would be left with the asset of a higher value than before. Thus, the housing boom turned into a bubble. The trigger to the entire crisis was when this bubble burst. The main reason was the inability of the mortgage borrowers to pay back loans as they had a poor credit history. This resulted in defaults.

People started forcibly selling their houses when unable to pay, thus settling for lower prices. Overall housing prices began to fall, making it more difficult for others to pay back their mortgages. As a result there was default after default and the market unravelled. This in turn affected the returns of CDOs (since banks weren't getting their money back, they were unable to pay the stated return). When investors realized they wouldn't get the promised return, they wanted their money back. But due to the drop in housing prices, this wasnt possible. Thus started a spiral of forced selling of sub-prime securities. This reduced the price of these securities in the market and thus the crisis grew new bounds. Even a small decrease in their asset values is enough to make such security funds bankrupt. As a result, several funds filed for bankruptcy. Companies like the American International Group (AIG) had insured the CDOs, but did not allow for such a catastrophic collapse in their value; they simply could not afford to pay out their insurance claims. Several companies in the US filed for bankruptcy, which led to the loss of thousands of jobs. People who invested through such funds lost their money. In other economies as well, such securities faced pressure to sell, leading to the fall of various non-US stock indices including the NIFTY and the SENSEX in India. Concerns about the soundness of US credit and financial markets led to tightening credit around the world and slowing economic growth in the US and Europe, which eventually spread to other nations, culminating in the recession of 2008. Figures that explain why these events took place may help you understand the matter better. The percentage of low-quality sub-prime mortgages in the US rose from the historical 8% to approximately 20% from 2004 to 2006, just before the crisis. Further, US households had become increasingly indebted, with the ratio of debt to disposable personal income (income left after paying taxes) rising from 77:100 in 1990 to 127:100 at the end of 2007, much of this increase caused by mortgages. This crisis was one of the major causes of the eventual bankruptcy (the largest in US history) of the Lehman Brothers Holdings Inc., a global financial services firm, which had significant exposure to the sub-prime lending market. In August 2007, Lehman Brothers closed its sub-prime lender, BNC Mortgage, eliminating 1200 positions in 23 locations. After facing unprecedented losses due to the continuing crisis, it eventually filed for Chapter 11 bankruptcy protection on September 15, 2008. Hopefully this long but simplified version of the crisis has given you some clarity on the events that took place. In this day and age of globalization, such major world events are in no way separate from us, and impact each of us individuals in one way or the other. To deal with them in a successful manner, understanding such events is of great importance.