Saturday, May 24, 2008

What is the subprime mortgage crisis??

Subprime crisis has been in for some 2 years but the latest survey reveals we hardly know anything about its causes or its long-term implications. Therefore, I took it on myself to unravel the hidden truths of the credit crisis and expose the faults in our financial structure alongwith the 'villains' who set it all up.

It all began when housing companies in the US began wooing prospective home buyers to buy land at cheap rate with a very small down payment and then enjoy a secure future. These homeowners, seeing the artificially rising housing prices, thought they should enter the scene too, and hey presto! a lot of us ended up buying homes with little or no capital to fund it. These people were given loans by mortgage lenders - companies that usually given loans to people to buy a variety of assets - land, cars, property and so on.

Further on, some of the 'greatest financial engineering minds' in the world created a system called sensitizations, which meant securitising the loans given to homeowners to make bonds to sell to investors(at obviously a lower rate of interest). Explained in the following paragraph.

Say $100 is given as loan to Mr. A at 12% interest. Then the loan company cannot further use $100 as it as already given it to Mr. A. So, it announces that it selling a bond of $100 at the rate of 10% interest(thereby making $2 on every home sold). This way the loan company gets another $100 to give to Mr. B(yet another homeowner) and his profits go on increasing. But this seemed a very risky proposition from the starting -- so they employed companies which were known as guaranteers in case the money was not received back from Mr.A(the homeowner) and Mr. B . These companies were Bear Sterns, Citigroup, Merrill Lynch, and many more [about a 100 odd] including Indian ones like ICICI Bank.


The moment these homeowners defaulted on their payments to the loan company, the loan company was liable to pay investors on the bonds they had sold. But since they had guaranteed their loans to companies like Bear Sterns, Citigroup, Merrill Lynch ---all the latter companies suffered heavily and took a huge beating on their balance sheets by dolling out billions of dollars in bad debts written off. This, in turn, led the prices of all housing properties in USA and the world over to fall --leading to a great credit crisis and consequently housing bubble that saw inflation rise to a great extent.

Most economists and analysts say that the worst is still to come. There is an estimated $1 trillion in mortgage backed securities in USA and around the world and the numbers keep growing bigger and bigger.

The impact this subprime credit crisis has had is alarming:

  • Around 100 mortgage companies have shut down

  • Wall Street stalwarts like Bear Sterns, Citigroup, Merrill Lynch have posted record losses

  • Homeowners in all parts of US have been affected tremendously

  • The Government Treasury and Federal Reserve have been hit very hard by the mounting losses

  • Just received news via reuters that home sales are slipping all throughout this year with the stock of unsold houses just piling up.


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