Subprime crisis

It is time to get technical. Cuff up. This ain’t gonna be easy. So what is all the hullah about subprime mortgage crisis? Over debated, less understood as is any financial term. Join me in this attempt to demystify it. Before getting lost or dozing off, let us first make sure of a few basics before progressing.

In very few words, the crisis is just a lot of loans that went bad. So this may lead you to believe that the banks that lend the money would have gone bust. But by the end of this discourse (if you manage to!!!!) you will discover that it was the borrowers and other people totally alien to the mortgaged houses who ended up losing.

Some terms to understand which will put the crisis in its right perspective include,

1. Mortgage
2. Sub prime market
3. Securitization
4. Refinance
5. Fed rate

Mortgage

The simplest of the terms, this refers to the loan secured in order to purchase a real estate property, mostly a house. The parties involved include the debtors or borrowers i.e. the one buying the house and the creditors or lenders, either a bank or other financial institution.

Sub-prime market

Based on credit history (borrowing history), people are divided into tranches (groups). The prime borrowers are those whose history of repayment has been good and risk of default is less assuming that they will continue to be as good as they have been. So this leads us to sub-prime borrowers, who naturally have had a bad credit history. This includes default of loans, delayed EMI payments and also declaration of bankruptcy.

So what is the point of lending money to someone who is likely to default? Here comes the crux of any financial market. ‘RISK INVOLVED JUSTIFIES THE RETURNS’. These borrowers are lent money at an interest rate that is much higher than the prime borrowers. This is under the assumption that the defaults can be compensated by the higher returns obtainable from the borrowers who repay.

Securitization

Technically it can be defined as treating any receivables, cash flows or assets as securities and bundling them and passing it onto investors.

Okay if that just buzzed by, in our context, it can be understood as follows.

A bank issues loans to borrowers. So it has a stream of future cash flows receivable. Now what the bank does is, it bundles up all the loans and sells this as a security (a financial instrument) to interested investors. For example, ICICI lends money for auto-loans. Say it has a pool of 1000 borrowers. Now it prepares a security and issues it to 1000 investors. These investors are assured of receiving the EMI payments of the borrowers.

Why has the traditional lending-borrowing model undergone a change like this? It is because as in our example, it gives ICICI bank more funds to lend again (as the securitized loans are sold) and allows it to specialize in evaluating credit risk and giving away loans. The investor himself cannot go and find 1000 people buying automobiles to lend a small amount to each one of them. Since the pool is large, it inherently has risk diversification. Thus it seems like a win-win situation for all.

Refinance

Refinance generally refers to replacing one loan with another. The motive behind refinancing a loan in the mortgage market is to get a lower interest rate and hence a lower EMI payment. Banks have a tendency to charge a rate of interest in line with the proportion of investment. That is for the same house, if the borrower pools in 20% and borrows for 80%, the loan will be cheaper (lower interest rate) than going for 100% borrowing.

For example let us consider, someone buys a house for $ 1 million in California borrowing 100% of the capital from say Citibank. Now in a booming real estate market, one year down the line, the property appreciates to $ 2 million. So now a new bank say Countrywide is willing to lend the owner $ 1 million at a rate lesser than Citibank as Countrywide is only paying 50% of the house value. Thus the owner is willing to refinance his loan as he is required to pay a lesser EMI.

Fed rate

The fed rate is the interest rate at which the banks can borrow from the Federal Reserve in US. This rate almost decides all the other interest rates applicable in the economy. So an increasing fed rate implies, floating rate loans are expensive and vice versa. The fed rate reached abysmal levels of about 1.75% in 2002. Since then the Feds have been increasing the rate 11 times in a row by 25 basis points( 0.25%) each time.

La crisis

So now that we (though few :D) are clear with the terms, let us delve a little deeper and try to figure out what caused the bubble to grow and then finally burst.

The low fed rate around 2002 made home loans cheaper. To fuel the housing boom, banks started to lend to sub-prime borrowers. The banks became so involved in disbursing new loans, that they relaxed their credit risk (repayment capacity) evaluation procedures. At heights of such lending, jokingly even NINJAs (No Income No Jobs Also) were given home loans. And moreover the banks also quickly securitized this sub-prime lending and sold it as securities to investors. These investors included pension funds, Mutual funds, financial institutions, other banks and big investors spread over US, Europe and other regions.

The demand in housing as a result of such reckless lending resulted in prices of houses skyrocketing. So people who had already borrowed started to refinance their loan on account of their appreciated houses. This reduced their EMIs. This created some strain on the banks and credit enhancement (We will delve into this part sometime later. Not today!!) agencies involved in securitization of the loans.

Now the fed believed the rates have been artificially low for long and started to raise it in 2004. Since then there has been an increase of 25 basis points (0.25%) 11 times in a row. Thus the EMIs increased which started to trigger defaults all around. This snowballed and the banks took over the houses of the defaulted people and put them on sale. But there were no takers. Hence the prices of these properties plummeted. Thus the bubble burst.

The people who were affected in all this were the investors in sub-prime mortgage securities. They had invested in it attracted by the higher rate of returns they offered. But the investors had no clue about the credit worthiness of the borrowers. They believed by what the lenders had to say. Also the defaulters are going to be affected in the future by way of poor credit evaluation. So now they will be tranched even lower than subprime borrowers. So the loans they take hereafter will be more expensive.

So how can all this be undone now? As an immediate relief the Fed is lowering its rate, thus making more funds available for the institutions on the verge of bankruptcy. But will that solve the problem is yet to be seen. To make sure this does not happen again, securitization should be done with prudence and the investors should demand access to the borrowers risk profiles. Also the real estate market needs better regulation and price discovery mechanism like the financial markets.

And if you are reading this line, WOWW!!!! We are at the same wavelength.

And if all this got a little heavy. Lighten up. Click below

http://youtube.com/watch?v=ewiXA_he6VQ

Touted to be the initiator of a global recession, how much ever we may deny, all our immediate future is inextricably linked with this phenomenon. But the most we can do is to watch how the drama unfolds.