ENTERTAINMENT INDIA

What is subprime crisis? How it caused financial mayhem?

he current upheaval in the global financial markets has caused more mayhem in a fortnight than the world has seen in its entire economic history.

Although there are many reasons responsible for bringing the world to the doorstep of financial doom, the main cause of this financial disaster is said to be the �sub-prime loan.'

So what is this sub-prime loan? And why has it caused global panic? If it is related to the American housing sector, why should it affect Indian and other markets?

A sub-prime loan

Sub-prime 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 buck.

Sub-prime loans are dicey as they are given to people with unstable incomes or low creditworthiness. These individuals are not financially sound enough to be given a loan when judged under the strict standards that should normally be followed by a bank or lending institution.

However, there's more to it. Let us simplify this issue to understand better how sub-prime loans work and how they brought the world down to its knees.

all begins with an American wanting to live the famed American dream.

So he seeks a housing loan to give shape to his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan.

Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments.

But lo!, before the American dream can fade away, there enters a second American -- usually a robust financial institution -- who has good credit rating and is willing to take on some amount of risk.

The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans -- like the first American -- who do not have a great credit rating and to whom the bank would not have given a home loan in the first place.

The second American gives out these loans at a rate of interest that is much higher rate than the rate at which he borrowed money from the bank. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market.

Also by giving out a home loan to lots of individuals, the second American is trying to hedge his bets. He feels that even if a few of his borrowers default, his overall position would not be affected much, and he will end up making a neat profit.

Now if this home loan market is sub-prime, what is prime? The prime home loan market refers to individuals who have good credit ratings and to whom the banks lend directly.

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.

Other than this, greater the amount of loan that the institution gave out, greater was the amount it could securitise and, hence, greater the amount of money it could earn.

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.

By giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and earn more money. Quite a vicious cycle, eh?

Now let's get back to the sub-prime market. The institution giving out loans in the sub-prime market does not stop here. It does not wait for the principal and the interest on the sub-prime home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has given it the loan. So what does the institution do?

It goes ahead and �securitises' these loans. Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors.

Many investment banks (or institutions like the �second American' in our story) sold complicated securities that were backed by debt which was very risky.

And how are these investors repaid? The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors.