Introduction: The 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 other markets around the world? 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 individuals who are not financially sound enough to be given a loan due to unstable incomes or low creditworthiness. Subprime lendings are of various types: o o o Subprime mortgages Subprime car loans and Subprime credit cards

However, there's more to it. Let us understand how Sub-prime loans work and how they brought the world down to its knees:

How destruction happened?

In the early 2000s, interest rates in the U.S. were low because there was abundant money supply. When interest rates are low in general it causes the economy to expand/ grow as businesses and individuals can borrow money easily which causes them to spend more freely and thus increases the growth of the economy. Institutions started offering loans to buyers with FICO scores of below 620. Because these borrowers were considered less likely to be able to pay back the loan, these sub prime borrowers were charged higher interest rate. Sub-prime home loans were given out as floating rate. A floating rate home loan as the name suggests is not fixed. Institutions giving loans started hedging these securities, securing themselves from the risk if incase the borrowers default also allowing refinance their loans. To solve these problems, Investment Banks came up with concept called Securitization. (Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest). The pools of these loans were termed as Subprime Mortgage Loans, Mortgage-backed securities (MBS), Adjustable-rate mortgages (ARM). Under securitization, banks sold these pools of loans to other big Financial Institutions, thus getting more liquidity and also transfer the risk associated with these loans.

As per regulatory norms, a large portion of the financial institutions that are potential purchasers of these mortgage pools are not allowed to buy or are restricted from buying sub prime debt because it is considered too risky. To get around this, what investment bankers did was took a pool which contained subprime mortgages and divided it up into different levels known as tranches. Each tranche thus had a mix of good and bad loans. Credit Rating agencies like S&P, Fitch, Moodys gave them different ratings for each level, but the ratings were much better than they deserved. This allowed investment bankers to sell off a large portion of the subprime loans as debt instruments with above prime credit ratings thus expanding the number of potential buyers of that debt. Many big fund investors like hedge funds and mutual funds globally saw sub-prime loan portfolios as attractive investment opportunities. The percentage of these subprime mortgages rose from the historical 8% to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S. Further in the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. Until 2006, U.S. economy was growing fast enough, the housing market was also flourishing (the price of the typical American house increased by 124% between 1997 and 2006) till the Federal Reserve (FED) decided to increase interest rates, which it continued to do until fed funds rate stood at 5.25% in January of 2007 (up from 1%).

Several things happened as a result of this:

Since many of the sub prime borrowers took out floating loans or teaser loans, with US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers hard. A lot of them in the first place had unstable incomes and poor credit rating, they defaulted!!! With interest rates began to rise, housing prices started falling in 20062007. Falling prices resulted 23% of U.S. homes worth less than the mortgage loans amounts and almost 50% from their peak in 2006 in some cases. Crisis bubble began to Burst of the United States housing. The economy began to slow down. These MBS for the most part were no longer with the smaller lenders as they had been sold off and traded among different financial institutions from around the World. Since these huge pools of pools rely on short term borrowing to buy the longer term debt and have to periodically roll the loans they are issuing over. Now, they could no longer borrow short term to cover their obligations and were therefore in danger of having to sell off huge chunks of these mortgages backed securities to avoid running into financial difficulty. As a result these ongoing defaults and falling prices, these global financial institutions who had borrowed and invested heavily in these securities reported significant losses wiping out their net worth. Total losses were estimated in the trillions of U.S. dollars globally.

Apart from the fact that banks based in other parts of the world also suffered losses from the subprime market, there are two other major ways in which the effect is felt across the globe: First, U.S. is biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in U.S. securities. Thus any crisis in the U.S. has a direct bearing on other countries, particularly those with large reserves like Japan, China and - to a lesser extent - India. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world. Impact on U.S. and Global Economies: o Global banks and brokerages have had to write off an estimated $512 billion in sub-prime losses so far, with the largest hits taken by Citigroup ($39.1 bn) and Merrill Lynch ($29.1 bn). o o o A little more than half of these losses, or $260 bn, have been suffered by US-based firms, $227 billion by European firms and a relatively modest $24 bn by Asian ones. Unemployment increased from 5.7% in 2007 to 10% in 2010 to 15.3 mn. Sub-prime crisis led to the collapse of: o Bear Sterns, one of the world's largest investment banks and securities trading firm in U.S. Bear Sterns was bought out by JP Morgan Chase. o Merrill Lynch and Countrywide Financial was bought out by Bank of America. o Freddie Mac and Fannie Mae, world largest brokerage houses which had roughly $12 trillion outstanding in home loan mortgages in U.S. were nationalized. o Lehman Brothers - fourth largest investment bank in U.S. filed for Chapter 11 Bankruptcy. There was a total of 2.2 million foreclosures in 2007, up 75% from the roughly 1.26 million RealtyTrac reported in 2006.

Few important measures taken by U.S. authorities:

Various government rescue programs were implemented to stabilize the financial system during late 2007 and early 2008. o o o o USD 700 billion Troubled Assets Relief Program (TARP) was announced by U.S. govt. to purchase assets and equity from financial institutions. Interests rates were lowered to 2% from 5.25% through separate sections between Sep. 2007 to Apr. 2008. Announced credit easing measure by creating liquidity and purchasing the mortgagebacked securities from the various institutions. U.S. Treasury dept. invested about hundreds of billion dollars in various banks & institutions through its Capital Purchase Program in an effort to prop up capital and support new lending: o o American Insurance Group (AIG) was bailed out by giving $182 bn bridge loan to tide over the crisis. Citigroup received $45 bn support in 2 instalments from U.S. govt.

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 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. The institution giving out the sub-prime loans takes the money that it gets by selling the financial securities and passes it on to the bank he had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Or so it would have seemed. The sub-prime home loans were given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the EMIs that need to be paid to service these loans go up as well. With US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers hard. A lot of them in the first place had unstable incomes and poor credit rating. They, thus, defaulted. Once more and more sub-prime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses. The problem primarily began with the United States keeping its interest rates very low for a very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower interest rates led to buyers wanting to take on bigger loans, and thus bigger and better homes But life was fine. With the American economy doing well at that time and housing prices soaring on the back of huge demand for real estate and bigger and better homes, financial institutions saw a mouthwatering opportunity in the mortgage market. In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures before extending housing loans to people with unstable jobs and weak credit standing.

Few controls were put in place to handle the situation in case the housing bubble' burst. And when the US economy began to slow down, the house of cards began to fall. The crisis began with the bursting of the United States housing bubble Sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgagebacked securities were almost worthless as real estate prices crashed. The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realised that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble. As defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market. Now burdened with tons of debt and no money to pay it back, the back of these financial entities broke, leading to the current meltdown http://en.wikipedia.org/wiki/Troubled_Asset_Relief_Program http://en.wikipedia.org/wiki/Subprime_crisis_background_information http://en.wikipedia.org/wiki/Subprime_mortgage_crisis_solutions_debate http://en.wikipedia.org/wiki/Federal_Reserve_responses_to_the_subprime_crisis http://money.cnn.com/news/specials/storysupplement/bankbailout/ http://en.wikipedia.org/wiki/List_of_writedowns_due_to_subprime_crisis http://economictimes.indiatimes.com/features/et-slideshows/us-mortgage-crisis-a-subprimer/whathas-been-the-impact-of-the-crisis/quickiearticleshow/3488710.cms http://www.rediff.com/money/2008/sep/25slid13.htm