Tuesday, September 4, 2007

US Sub-prime Crisis

The US sub-prime mortgage lending crisis or simply sub-prime crisis has been the catchphrase in various media over the last few weeks. In this entire hullabaloo, one may want to know what this episode is all about and how it will affect the Indian economy or rather the world economy as a whole. Let’s have a look.

Sub-prime borrower
In US almost everything, right from getting a credit card to receiving various banking services, is dependent on the credit history of a person. 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. and is denoted by the FICO score or credit score of a person set by few credit rating agencies. It is easy for a person with a good credit history to get loans and other services while it’s exceedingly difficult for a person with a not so good credit history or low FICO score to avail banks’ services, let alone loans. Such poor credit history borrowers are called sub-prime borrowers. Since there is a risk of default on loans to sub-prime borrowers, US banks usually charge a higher rate of interest to them for the risk they are taking. From the bank’s side, a higher interest means a higher return, well with a risk. As a result, some banks had seen lending money to sub-prime borrowers as an opportunity.

Sub-prime boom
For a crisis to happen, first there has to be a boom. There were a few things that led to the sub-prime boom. I better quote Christian Stracke of Financial Times who had explained the situation quite nicely. “It all originated with a global imbalance between the supply of credit and the demand for credit. Global Central Bank let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system. At the same time, corporate, the traditional mainstays in terms of borrowing funds to invest moved to a defensive stance, having grown much more conservative in the wake of the Enron and WorldCom fiascos. Finally, the major developed countries began to gain a measure of fiscal discipline, with budget deficits shrinking, which further reduced the demand for credit on a global basis. That imbalance between investors flush with cash and the traditional borrowers not really needing or wanting that cash meant that investors had to look for new markets to invest in. As the Asset Backed Securities (ABS) market had been taking off and coming into the mainstream, a natural target was the sub-prime borrower - borrowers who in the past had wanted to borrow but who had been locked out of credit markets. Eager lenders met eager borrowers, with the mortgage originators, ABS underwriters, and credit ratings agencies playing the role of matchmaker, and the sub-prime boom was born.” Now, let's see what the banks or mortgage originators did to target the sub-prime borrowers’ market.

Role of Banks and Hedge Funds
So there was an opportunity among sub-prime borrowers and there has to be someone who could take the money from investors and give it to the borrowers. Who could do this better than the banks? Banks gave money to sub-prime borrowers and then they bundle the loans to a package and sold securities whose value was linked to the performance of the package of mortgage loans. Investors bought these securities and thus indirectly provided the money required for sub-prime lending. These derivative instruments are called Collateralized Debt Obligations (CDOs), which is one form of Asset Backed Securities. Thus, banks did away with the role of playing a financial intermediary. The total volume of CDOs in the US market is around $900 billion and only 17% of the CDOs were created out of sub-prime mortgages. Hedge Funds hold majority of these sub-prime related securities due to the inherent nature of their business making them extremely vulnerable to sub-prime related issues. So everything was set and now let’s find out what triggered the crisis.

Sub-prime crisis
Quite obviously the sub-prime crisis occurred when the sub-prime borrowers defaulted in their mortgage loans, which affected the returns of CDOs. The main reason was the inability of sub-prime borrowers to pay back the money. Another catalyst was the rising segment of credits like Home Equity Loans through which the borrowers could take a second credit on the same mortgage. These added to their inability to payback the money. As a result, some defaulted. Some started force selling their houses due to which property prices came down, which made it more difficult for other sub-prime borrowers to refinance their mortgages into loans with lower rates. The result, more and more defaults!

Now at the securities side, the highly leveraged hedge funds, found themselves in distress due to the rising defaults by sub-prime borrowers. Investors who had put their money in these funds wanted their money back which forced these funds to liquidate their assets. And thus started a vicious 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. Since hedge funds are highly leveraged, a small decrease in their asset values is enough to make them bankrupt. As a result several funds filed for bankruptcy. Thus the sub-prime crisis showed its red face!

Effect on global and Indian economies
Few companies in the US filed for bankruptcy which led to the loss of thousands of jobs. People who invested through hedge funds lost their money. UK and Japanese economies were affected a lot as there were a lot of money from investors belonging to these geographies that had been put into sub-prime securities through the hedge funds.

In other economies, hedge funds faced selling pressure to meet margin calls which led to the fall of various non-US stock indices, Sensex, Nifty being few of them!

Though not severe, Indian economy got affected by this in the following ways. A reduction in the investments in Indian securities/major selling of Indian stocks by foreign investors (foreign funds having CDOs created out of sub-prime loans and had selling pressure) and a subsequent melt down of Indian stock markets, IT companies losing few of their clients belonging to US mortgage industry & Hedge Funds due to cost cutting or bankruptcy are some of these.

Analysts say that the US sub-prime crisis is not over yet. Let’s see what more this disaster has in its store in the days to come. In the hindsight, one might think, had the banks been not greedy enough to put their money in riskier sub-prime borrowers and made securities out of it!

Related Articles
- Lessons from the sub-prime crisis


Ajith said...

That was insightful..What has made this article more attractive is that the reader does not need to be aware of high financial funda to understand this..Good job :) ..
Seeing the way banks like ICICI and HDFC offer loans to virtually any tom dick and harry, do u forsee something like this happening in India later ?

Jithu said...

> ajith
thanks man, u were the first one to comment on this blog :-)

I shud say that the verification proceedings of banks in India b4 giving out such loans are not so weak. I guess that shud take care of the major part. Also, one cant take a secondary credit on his mortage in India (like HEL and HELOC in the US). This wud prevent the borrower from having additional burden of payments and thus wud save him from defaulting.

But one cant say that things similar to US sub-prime crisis will not happen in India. Things cud happen. If not in one way, then in another. Hence banks shud take it as a lesson from their US counterparts and improve on their existing service offerings/verification processes.

Anonymous said...

Hey Jithu,

Great article man, you had explained the Sub-Prime term in a layman's words. I really appreciate your effort. And this blog is also very useful with good stuff.

Anonymous said...

Thanks Jithu for the wonderful blog. I found it very useful...

GOPIKANT said...


Anonymous said...

Good chunk of info for an average indian..

Anonymous said...

It has been presumed that the stock market prices cannot be predicted in the light of Random Walk hypothesis that contrasts the basic tenets of Efficient Market Hypothesis. But there has been ongoing attempt from researchers around the world and one by particularly undertaken research to contradict this evidential inference about the proximity of deluging the ‘Random Walk’ theory.

There has been one important findings reported in SSRN website titled ‘Calculating Stock Market Index Closing Value Using Risk Function Curve Equation, Logistic, B-Spline Curve and Polar Conversion techniques’ which catapults and attempts to accurately measure the intraday ranges of an index using Risk Function Curve. What this paper says is that, stock prices and index movements can well be predicted mathematically using the simple equation mentioned in these paper. The equation uses index variables to compute and provide a range of values which has been tested consistently, and found out to be non-erratic.

However, it is difficult to understand the basis of this particular equation wherein, some strange forces have been acting to compensate the changes in variable units. This particular equation modifies the ‘r’ function, or the risk function that helps to deduce how much risks are there in a market, thus quantifying the amount of risk of an index for a particular day.

The author points that by keeping the other variables constant; one induces changes in value in ‘r’ in the equation which gives the output range, and often the true exact closing price that the index may close on that particular day.

I find this event violate the random walk theory and EMH principles in question some what arbitrarily. Then, shall it be mentioned here that index closing prices can be accurately predicted using mathematical functions? And then, why is that happening?

And if this is the case, then it would create trouble in the financial world and markets where one would basically apply any trading positions (index long or short) in advance which would rather bring more inefficiency within the markets or in other way, bring perfect efficiency thereof remains particularly to be known.However, it may be probable to predict stocastic trends in stock moments in times of volatility.

Vivek Singh said...

nice post Sujith... I discovered your blog pretty late though

The Analyst said...

like u i have started my own blog on finance it focusses on global finance and issues around it.

Along the lines of your article my blog is mostl concentrating on the financial crisis.

please add a link to my page:

any of your expert opinions are welcome

santu from santosh nagar said...

Thanks Jithu
This is subprime crisis made easy. I was looking for such a thing since a long time.

Better4worse said...

Hey Sujith,

Dman nice blog...keep churning out more such posts !


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The subprime crisis in the us is all because of the big investment banks gone wild.

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