Sub-Prime Crisis: An Economic Perspective

Collapsed (Individuals + Corporate + Banks)= Collapsed System

Sub-Prime Crisis An Economic Perspective

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The days of high levels of employment and high disposable income in the hands of individuals saw

1995 – 2006: The Bright and Sunny Days…

High demand for commodities and goods

Source: www.bloomberg.com PaisaMatters.com


Increasing demand led to increased production levels

Jobs creation and an all around industrial and economic growth

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Source: www.ofm.wa.govPaisaMatters.com

Source: epress.anu.edu.au



The consumer generated organic infusion of money generated strong liquidity in the economy

The increasing aspirations and risk taking ability coupled with low interest rates fuelled strong credit growth

Banking system flushed with liquidity felt a need to accelerate the credit growth

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High income levels and desire to own a dream home had already created a good mortgage loan portfolio


Low interest rates made the housing more affordable and allowed to borrow more

The prime mortgage loan market was falling short of propelling the desired exponential credit growth

There was a huge population with ‘less than perfect credit’ to be tapped

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Borrowers with less than perfect credit - the Subprime borrowers, presented a mouthwatering opportunity for bankers in the mortgages market


Banks started chasing the subprime borrowers with easy loans

People who otherwise could not have afforded a home, bought homes with the high interest rate loans

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Welcome to the world of

Sub-Prime Mortgages

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Subprime loans are mortgages given to borrowers with ‘less than perfect’ credit or poor credit history

Most subprime borrowers are ones with low and inconsistent income

Because subprime loans are riskier, they carry a higher rate of interest

Not all subprime mortgage loans were used for buying houses but to refinance other obligations like credit card debts, making them even more risky

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Borrowers were happy to get loans without worrying about credit worthiness

Mortgage brokers were happy as they were paid to underwrite these easy selling subprime loans without a responsibility to recover

Bankers were happy with the credit growth and higher returns from subprime loans

A Win-Win for all, but not for long.

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The bankers who originated subprime loans converted them to bundles of securities and sold the packaged Mortgage Backed Securities (MBS) in financial markets

This allowed banks to pass on the risk of default to investors of MBS

This allowed banks to get these loans off their balance sheet and borrow more, only to originate more subprime loans

The buyers of these subprime MBS thought they were taking a calculated risk of default in lieu of higher returns

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In the “High Risk – High Reward” equation, the involved risks were grossly overlooked for the lucrative rewards

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Low interest rates

+

Rising property prices

+

Banks chasing after borrowers with easy loan offers

Result

Swollen sub-prime mortgage portfolio &

huge debt ridden populationSource: i.ehow.com

Source: Flickr.com

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Q4 2006 – Q2 2007: The Gloomy Evenings

Too much money chasing too few goods resulted in increase in commodity prices and rising inflation rate

The interest rates started moving northwards

Because most of these loans were Adjustable Rate Mortgages (ARMs), the loan installment amount increased

Pressure started to mount on borrowers monthly cash outflows to meet the fixed obligations

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Q4 2006 – Q2 2007: The Gloomy Evenings..

Falling demand for properties led to a rapid decrease in property prices

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Q4 2006 – Q2 2007: The Gloomy Evenings..

Rising oil prices and falling stock markets saw an erosion of investments

Decreasing demand all around resulted in reduced production levels and job losses

Economic slowdown was slowly making an entry

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Q3 2007 Onwards: The Scary Nights…

The subprime borrowers with inconsistent and low incomes could not pay the increased loan installments

Banks started to tighten the credit norms preventing subprime borrowers to refinance existing debts to lower payments

Borrowers could not sell the property to repay debts as the house was worth less that what they bought for

This left borrowers with an option to bring in more money or miss the loan payments

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Improving cash flows was a distant possibility for sub-prime borrowers, missing payments was obvious

The sub-prime loan defaults started mounting

With a further continuous increase in interest rates, it became almost impossible for borrowers to repay the increased mortgage bills

Loan foreclosures started increasing

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http://images.google.co.in/imgres?imgurl=http://www.news.com.au/common/imagedata/0,,6099071,00.jpg&imgrefurl=http://www.news.com.au/dailytelegraph/money/story/0,26860,23883197-5015795,00.html&h=285&w=633&sz=26&hl=en&start=3&um=1&usg=__hpN2PdRSbx5MEKoo_b2tNg29uNw=&tbnid=evSWeD_ibsK8rM:&tbnh=62&tbnw=137&prev=/images%3Fq%3DUSA%2Bmortgage%2Bdefaults%26um%3D1%26hl%3Den


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Because there were not many buyers for foreclosed properties, banks could not recover their outstanding loans by selling the foreclosed properties

With tightened credit norms, fewer borrowers qualified for new loans leading to more homes to sell to fewer buyers

Banks left with no other option but to write off the outstanding defaulted loans

Once considered cash cows, the high return fetching mortgage backed securities (MBS) became worthless

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In deteriorating economic conditions, sub-prime loan defaults were followed by defaults in

– prime mortgages

– home equity loans

– unsecured consumer loans (car loans, student loans, credit cards) and

– commercial loansPaisaMatters.com

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Tons of outstanding credit with no recovery in sight saw financial institutions broke

This caused more than two dozen lenders to close, sell themselves to larger firms or report unprecedented losses

Once massive, some financial institutions filed for bankruptcy

Source: nancarrow-webdesk.com

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The panic started to spread

Stock markets crashed

Lost confidence in financial system

Wall street pillars started crumbling

USA is witnessing one of the largest systemic collapse in its history

Source: newsimg.bbc.co.uk

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Financial Times – 20 September 2008

“…bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators

and credit rating agencies.”

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?: The Dawn Ahead…

Costly though, surely, a lesson for the economy

Is the worst over yet? … Probably not !

How long before the economy starts looking-up again? …Nobody knows!

Hopefully Sooner, is the Dawn Ahead…

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Sub-Prime Crisis: An Economic Perspective

Economy & Finance

Transcript of Sub-Prime Crisis: An Economic Perspective