SUBPRIME CRISIS-EXPLAINED!!!

We all know this as crisis of 2008. But many do not know clearly this crisis.

In USA the banks gave loans to SUB PRIME customers. 

Who are SUB PRIME CUSTOMERS?

 The one who are not prime customers, that is, below prime customers.

Who are PRIME CUSTOMERS?

The customers who can pay back the loans easily.

Also having the good credit score and has not done any default in the past.

So they get loans at attractive interest rates.

But subprime customers are having very low credit score. Also they are not given any loans if they default in past.

But between 2004-2006, these loans increased too much.

Historically subprime loans used to be 8% of the total loans but it increased to be 20% of the total loans by 2006.Along with this prices of the properties also started increasing.

Why prices of the property had increased?

All these subprime loans given by a bank, Further that bank used to create fancy securities; these securities were called mortgage-backed-securities and their derivatives were called collateralized debt obligations; then these fancy securities were further sold out to European banks and Insurance companies.

Now all the securities or bonds formed, are rated by rating agencies. So further any institution or investor invests in that security or bond on that rating.

So here comes also the role of rating agencies who also do not do their work diligently. So they need to be blamed also.

Let's understand more deeply the Economic turmoil of 2008.

Let's say there are five home  buyers wanting a loan of two hundred thousand dollars each, so the bank would lend a total of 1 million dollars to these five home buyers @ 6%, now in addition to that what the bank would do is instead of giving out their own money the bank will get one million dollars from a rich investor named Rishi and then they would distribute his 1 million dollars into five parts as loans to home buyers and in return they would agree to give Rishi 3% interest so you see what happened the bank is charging 6% interest to the home buyers but is giving a 3% interest to Rishi therefore the remaining 3% will be the bank's profit, this is what you call as Mortgage-Backed-securities

Mortgage-Backed-Securities whereby the bank takes a group of loans and sells them to an investor such that the investors get returns and the bank gets profit without investing their own capital so now Rishi is happy that the bank is taking the risk of finding credit worthy borrowers, The borrowers are also happy because the bank is quickly disbursing loans and the bank is happy because without using their own Capital they are still able to make a profit with 3% interest.

Now pay attention to this as more and more loans got disbursed the bank executives got scared so these banks went to insurance company and by giving one percent fee to get their one million dollar loan units in short, they would pay ten thousand dollars as insurance for a one million dollar loan unit or one million dollar worth mortgaged backed securities, so tomorrow if these home buyers are not able to pay back these loans, the insurance company will have to pay the bank 1 million dollars that is what happened in 2008 and these insurance companies were none other than companies like American International Group (AIG) bear stones and the infamous Lehman Brothers disbursed One million dollars it's taking no risk at all because they have their home loans insured.

And this where the problem began since these banks were able to get their loans insured for just one percent of the amount they became extremely careless and kept on giving loans to every Tom Dick & Harry in fact after a certain point these banks were giving out loans so easily that in 2007 a 22 year old stripper was able to get a 2.4 million dollar loan and bought 10 houses in just 90days and this is where something crazy happened soon enough when too many homes got into the market than needed and within sometime the cost started to go down, rents went down and people started defaulting on the loans and when this happened the bank started facing a cash crunch so what did the banks do they went to insurance companies to get paid for the defaulted loans but this is where there was an even bigger problem as it turns out the insurance companies insured so much money that they themselves went bankrupt.

 Looking at the figure above, if 200 banks got one million dollars worth of loans insured by paying a one percent ($10,000) fee So only they get $10,000*200= $20,00,000.

Though they insured 200 million dollars worth loans but had only 2 million dollars as revenue which means they could only reimburse 2 banks for their 1 million dollars of default and they did not have any money to pay rest 198 banks whose customers did not pay back the loans so in short, the probability got messed up so now that the insurance companies did not have any money, they had to start selling their own assets and start paying the banks and if they could not they went bankrupt and this is exactly what happened to Lehman Brothers.

They gave out so much Insurance to Banks and investors that they had accumulated 85 billion dollars worth of portfolio which was four times the value of its shareholders equity and since they could not pay back even after selling all their assets they went bankrupt and this is where the chain reaction started when Lehman Brothers went Bankrupt. Most of these banks who could not recover their money, they lost billions of dollars, the  rich investors like Rishi did not get their money back and some banks and investors even went bankrupt and this is what led to a spiral effect whereby the real estate companies could not get loans and since nobody was buying houses the construction company could not pay their loans and since these projects were unsold, these construction companies could not pay their suppliers and those suppliers  could not pay their suppliers who could not pay back their bank installments eventually people lost jobs. 

Companies went bankrupt and all of this snowballed into catastrophe that caused one of the worst economic crisis in human history wiping out two trillion dollars of investor wealth from the stock market.

This is how 2008 recession happened!

Writing this relates with the recent news related to A credit agency brickwork  has been asked by SEBI to wind up its business. This is the important decision taken by SEBI which was not taken then by SEC (Securities Exchange Commission) USA against various rating agencies who had given AAA rating to junk bonds. So such rating agencies can also be blamed for the 2008 economic recession.

Again in India RBI had control over sub prime loans. But it's individual banks due diligence matters. So robust risk management is very much necessary in each and every bank in India in order to avoid any 2008 like crisis.