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Sub-prime crisis

Meaning of sub-prime

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Sub-prime lending extends credit to people who do not have access to the regular credit market.
It could take the following forms:

  • Loans to borrowers who have an existing history of loan delinquency or default
  • Loans to borrowers already bankrupt
  • Loans that do not meet guidelines stipulated by Fannie Mae or Freddie Mac
  • Loans based on property that cannot be sold on the primary market

Such borrowers who obtain funding on a sub-prime basis are termed as sub-prime borrowers.

Sub-prime mortgage loans – Seed to the crisis

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More and more loans were given to higher-risk borrowers to benefit out of the booming market.  The spread between prime and sub-prime mortgage interest rates came down drastically from 2.8% in 2001 to 1.3% in 2007 to induce the borrower thereby compensating on the risk premium. The risk premium was compensated in-spite of the decline in the credit ratings of the borrowers.

To make the best out of the markets, the following fancy loans were also being provided:  – “No Income, No Job and no Assets” loans, also referred to as Ninja loans

  • Interest-only adjustable-rate mortgages (ARM) where the homeowner pays just interest (not principal) during an initial period.
  • “Payment option” loan, where the borrower has the option to pay any variable amount at his discretion but interest not paid is added to principal.

Background of sub-prime

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Sub-prime mortgages formed a major portion of the overall mortgage market being estimated at $1.3 trillion as of March 2007. These mortgages had little or no upfront payment was made and issued to low/minority income/assets groups with low credit profiles. In third quarter of 2007, sub-prime ARM’s amounting to 7% of overall mortgages outstanding in US accounted for 43% of foreclosures initiated during that quarter and by May 2008 delinquency had risen to 25%.

After a long bullish trend on real estates, declining house prices in 2006-07 and increasing interest rates resulted in increasing delinquencies and foreclosures. This triggered a drop in market value of all the securities/derivatives derived out of underlying sub-prime mortgage loans. This erosion in market value has adversely affected the capital of various banks and financial institutions dealing with such securities like Fannie Mae and Freddie Mac. American real estate prices are almost down by a fifth and expected to recede a further 10-15%.

According to the International Monetary Fund (IMF), losses related to mortgage based debt and derivatives originating from America would reach $1.4 trillion. Already approx $760 billion has been written off by banks, insurance companies, hedge funds etc., on account of these losses. Also, IMF expects American and European banks to shed $10 trillion of their assets, which would be equivalent to 14.5% of their stock of bank credit in 2009.

Meaning of sub-prime mortgage crisis

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The term “Sub-prime Mortgage Crisis” refers to the current financial crisis which was primarily triggered by increasing delinquencies and foreclosures in mortgage loans in US and hence affecting major banks and financial markets around the globe adversely.

The last time the world faced such a situation was after the stock market crash in October 1929. It took three years to launch efforts to counter the recession that engulfed after the crash resulting in collapse of majority of banks, deflation, unemployment, slump in economy etc.

Just like the previous recession, economic factors like inflation, rising commodity prices, housing bubble along with globalization and innovation in financial markets were seen independently and never in tandem, hence never feeling that recession has set in, until it was too late.