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Subprime crisis: history, players and implications on India

Posted by VASUDEVA REDDY on Tuesday, October 25, 2011 Under: economic articles

Subprime is the cause of USA Economy slow down.  It is the very popular news among everyone and it is become very serious then expected. It caused more damage to all the industries especially Banking, Insurance and Automobile sectors. Subprime crisis caused big loss to the banks and now it is affecting the other industries like Auto Mobile companies (GM, Ford, etc.). In this blog I will write about what exactly is the Subprime crisis and why USA banks created such a big mistake in their era. Some experts comparing this disaster with the 1930 Economy slowdown in the USA.

Subprime loan:

Subprime loans tend to have a higher interest rate than the prime rate offered on traditional loans. The additional percentage points of interest often translate to tens of thousands of dollars worth of additional interest payments over the life of a longer term loan.


 


However, getting a subprime loan could still be a good idea if the loan is meant to pay off a higher interest debt (such as credit card debt) and the borrower has no other means for payment.

The specific amount of interest charged on a subprime loan is not set in stone. Different lenders may not value a borrower's risk in the same manner. This means that a subprime loan borrower has an opportunity to save some additional money by shopping around

Subprime lending:

Subprime Mortgage Loans (or housing loans or junk loans) are very risky. But since profits are high where the risk is high, a lot of lenders get into this business to try and make a quick money. These loans are given to people who have inability to repay the loan and they don’t have stable income. For example, a person who is working on IT company earns Rs.40000 per month and he doesn’t have any other income or assets. When the bank gives him loan of some lakhs, the EMI for the month would be Rs.20000-Rs.30000. If he lose the job, there is no possibility for him to pay the EMI, he will just surrender the house to bank and go away. This is the one simple example how Subprime problem starts.

Players to blame on:

Lenders: the biggest culprits behind the crisis:

Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default.




 When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments.

Subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.

Borrowers/ home buyers:

Many borrowers played an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and minimal initial costs such as "no down payment". Their hope lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly.


 


As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression that there was no risk to these mortgages and that the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable.

Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.

Investment Banks:

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum.


 


 A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.

 

 

Credit rating agencies:

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad.


 


Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated.

Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand.

The investor himself:

Just as the homeowners are to blame for their purchases gone wrong, much of the blame also must be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums over Treasury bonds. These enticingly low rates are what ultimately led to such huge demand for subprime loans.

Much of the blame here lies with investors because it is up to individuals to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the 'AAA' CDO ratings at face value.

Hedge funds:

Hedge fund is an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Hedge fund industry aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem.

To illustrate, there is a type of hedge fund strategy that can be best described as "credit arbitrage". It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.

 

Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls.

Subprime crisis: implication for India:  

In August 2007, India was on a sustained growth path, close to 9 per cent, the rise in trend growth underpinned by a sharp increase in both domestic savings and investments from under 30 per cent of the GDP to over 35 per cent within a space of five years. Wholesale Price Inflation (WPI) was within the tolerance band of 5-7 per cent. Global optimism regarding India’s future growth prospects, particularly that of its burgeoning Information Technology (IT) sector, was generating a tsunami of capital inflows that kept the central bank battling on two separate but interrelated fronts: Mopping up excess dollars to prevent appreciation of the rupee and sterilising the monetary fall out of this reserve accumulation to keep inflation in check.


 


The sub-prime crisis did not affect India directly. Indeed, the initial expectation was that robust growth in China and India would rescue the global economy as emerging markets had ‘decoupled’ sufficiently from OECD (organisation for economic cooperation and development) countries. This resulted in an influx of capital, currency appreciation and a stock market boom. However, once the credit storm in western markets combined with the spike in commodity prices to coalesce into a ‘perfect storm’ of faltering growth and high inflation, the second round effects appear ominous. The rise in oil prices dealt a severe terms of trade shock that sharply worsened the current account, increasing India’s merchandise trade deficit by 50 per cent in April-July 2008 over the corresponding period last year.

Firstly, the sub prime crisis has led to near loss of confidence in the American Stock Markets, and this has accentuated the credit crunch. Many big investment banks have been brought down to their  knees and many others are finding it extremely difficult to stay on their feet. In order to consolidate their respective balance sheets in the United States, these banks are unwinding positions in developing markets hence causing down swing in these markets. A simple case in point was the intraday 1400 points fall on the BSE in January 2008 that was brought about by Citi Bank unwinding its position in many front line stocks in India. The sub prime that was brought upon by the American financial system upon itself is spreading its tentacles around the world. People who were not even remotely connected with the sub prime crisis are being adversely affected.

Secondly, the near recession situation in the USA has led to a loss of demand for Indian exports hence loss of export earnings for India. Not only is there a loss in the goods sector, but the IT sector is also feeling the pinch. Software development for many US firms takes place in India but as the American firms are facing an economic slowdown, they demanded less IT products, lead to a fall in the growth rate of the Indian IT sector.

Thirdly, investment banks and other financial institutions are on a job slashing spree to cut costs lead to increased unemployment in India.

Fourthly, there will be serious implications for the banking sector as well. Crisis lead Indian banks to follow strict rules to disburse loans which reduced the pace of growth.

 I didnt write this article, i just gathered some data and sorted it out. the credits goes to,

www.investopedia.com
www.business-standard.com
Mr. Anand Shankar, who wrote an article named, 'The Subprime Crisis-Implications for india' and some more
 

In : economic articles 


Tags: sub prime crisis india implication culprits investment bankers credit rating agencies lenders bubble housing 

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