Sub Prime Crisis

It came into light in August, 2007 and created a snowballing effect in Global Markets and shook the entire financial world. Yes I am talking about Sub-Prime Crisis and its ripple effects not only on US Economy but Economies world over.
What is Sub-Prime Lending:
Sub-Prime Lending means lending to people having a little or no creditworthiness or to the people who have a poor credit history. In context of US housing markets, such lending was possible because of manic house buying, fraudulent lending practices and a very little oversight by regulator.
How it all started:
It all started with dot com burst of 2000-2001. The US stock markets were down and languishing. The then prevalent benign interest rate ensured lot of liquidity in the hands of US investors and institutions. The only attractive investment avenue available then was housing. The demand for housing started increasing due to two reasons one being that rising prices led to speculation and second being the fear among the masses that they won’t be able to buy houses if the prices kept on increasing in secular trend. Under the pressure to maintain margins US Financial Institutions started lending to borrowers with poor credit history overlooking the regulatory and prudential norms. The incentive was to earn higher mark-up in term of interest rates. They shifted the entire such loan portfolio by selling them off in secondary market through the mechanism of Securitization. So nothing was kept on books and the capital was freed instantly. As housing prices were rising relentlessly the Financial Institutions were confident that even though the Sub-prime borrowers defaults they will be able to service the securitized issue by recovering the defaulted amount and losses by foreclosures and selling the properties at much higher prices in ever rising market. They fail to understand the basic rationale that whatever goes up frantically comes down with double the pace. The size of US mortgage industry in late 2007 was approximately of $10.74 trillion out of which the Sub-prime mortgage were of the size $1.30 trillion and in 2006 alone $600 billion of Sub-prime mortgages were originated.
How it resulted in Crisis:
The housing demand led to construction boom and helped US economy to remain afloat. But due to rising trade deficit and China’s (US had a huge trade deficit with China) reluctance to abandon its fixed band exchange regime, as it could have dampened its export oriented growth put pressure on Fed Reserve to start raising the interest rate. From 2004, there was a steady increase of interest rate which affected the housing demand. The housing supply side reacted but with a lag thus creating a pile up housing inventory. Also because of rising interest rate the adjustable rate mortgages started getting resets at higher level which the Sub-Prime borrowers ill-afford to pay. Suddenly, such borrowers realized they that the cost of their Mortgages has increased substantially. Reset at higher rates and stagnant housing prices led to increase in defaults leading to massive foreclosures.
Effects of Crisis:
1) The Credit norms were suddenly tightened which lead to severe liquidity crisis. The liquidity from the market vanished so rapidly that it has put US on the brink of recession.
2To avoid liquidity problems and thus falling consumption levels Fed first announced the rate freeze and then started cutting interest rates.
3Many big financial institutions and banks like Citibank, UBS have to write down losses because of heavy exposures to Sub-Prime lending. Bear Stearns one of the active players in the space became virtually bankrupt and was taken over by JP Morgan Chase and Co. at substantial discount to value which it commanded before the crisis broke out.
4Investors in MBS and CDO’s market saw there investment value depreciating rapidly. A lot of them were institutional investors aboard and they also burnt fingers in the crisis.
5There was sudden emphasis on cost cutting and many financial institutions started resorting to job cuts. These also has severe impact on traditionally consumption led US Economy.
6The falling value of houses led to negative equity which means that houses value dropped below the mortgage amounts. So even Prime Borrowers started defaulting as they did not see any incentive to service mortgage which was more than what the actual prevailing value of house was.
There were many other adverse effects like global slowdown, reverse flight of capital invested in emerging economies and depreciation of dollar against major currencies etc.
Conclusion
It is said that the crisis seen so far is only a tip of ice-berg. There are many more skeletons to fall. The Fed has no other option but to provide succor through rate cuts. But these will provide only temporary relief. It also needs to tighten the credit norms and see that they are followed in letters and spirit. The Fed need to go deep, find and punish the actual culprits who held the entire system to ransom. Apart from cutting rates Fed should also encourage refinancing and repackaging of Sub-Prime Mortgages. By cutting rates only Fed will do nothing but follow the vicious interest rate trap in which it find itself whenever such crisis breaks up. The rate cuts have already put more money in the hands of Speculators who are now chasing commodities especially crude. Hope the Fed is alert enough to avoid another asset bubble being created this time in commodities.
By Ajaykumar Shaha
Student - ZCBI