"Subprime" has been the buzzword (nightmare for some) in financial circles since the start of year 2007. What makes this topic really important is the huge impact on US economy and hence the world economy (will discuss this relationship later).
What is Subprime? Subprime literally means 'relating to (or for) people with a poor credit rating', that is for people who have been defaulters in the past or who don't have enough healthy assets to keep as mortgage with the lenders. These people cannot procure money from the prime market.
A market is called subprime market when the money lenders give money to people without verifying their credit rating but at higher rate of interest (than the prime market) in order to earn greater profits. In the early part of this decade, the U.S. economy was doing well and people had cash and the will to spend. Also the positive feeling in the financial industry (also known as the Wall Street) and a rosy picture of the US land market by rating agencies was a boost for property market and the associated bonds. Hence people were ready to spend more than they could possibly earn and so procured loans from banks and other firms. The property rates in U.S. were increasing at a fast rate and no one wanted to miss the opportunity. People took multiple loans from subprime markets keeping (inflated) property as mortgages to invest further in house market thus increasing the property prices even more. They were happy as they could see their investment soaring and making money for them.
How did the crisis start? The subprime crisis surfaced when people started defaulting on the loans. This was inevitable because these loans were given without proper checks to people without jobs or assets. The banks confiscated their houses and started looking for buyers to recover the money. When this started happening, it triggered a vicious circle. Now people were not finding it easy to get loans as easily as before and so there were few buyers in the inflated property market. Thus the prices started falling (less demand and more supply). The decrease in the property rates meant a decrease in the value of the houses owned by borrowers and hence that of mortgaged houses with the lenders. There were more defaulters pulling the property rates further down (a decrease of more than 8% average) hurting the market even more.
How did the subprime meltdown spread and gain such big proportion? The banks who gave money to the mortgage lenders and bought these loans were supposed to scrutinize the loans. But they did not care about late payments and early defaulters as the risk was divided among investors through the sale of resulting bonds and securities that were sold to investment firms, hedge funds, mutual funds, etc. by the banks. (The securities are called RMBS-Residential Mortgage Based Securities which are further sold as CDO-Collateral Debt Obligation).
The participation of investment banks, hedge funds and mutual funds in subprime mortgage led to a spread of the losses among the investors which resulted in a credit crunch in the US market. Investors started loosing faith in the market and went on a frenetic selling spree leading to a drop in the share prices of almost all the sectors. Thus money has been sucked out of the US market and this credit crunch is the reason why experts are predicting a recession in the whole US economy. Big investment banks and lenders have subprime writedowns in Billions of dollars. The worst-hit so far are Citigroup and UBS. Goldman Sachs and Lehman brothers are the rated investment banks with minimal presence in the subprime mortgage market (as of now) and are speculated to be eying this meltdown as a good investment opportunity (this it self can be discussed at length).
What is being done to contain the damage? The Federal Reserve (America's central bank) has been trying its best to avoid a full blown recession by decreasing the interest rate at a pace unprecedented in its history. The latest cut was been done as recently as 30th Jan by 0.5 % points to reduce the interest rate to 3% (the short term interest rate has fallen by 2.25% since Aug 07) in order to avoid credit crunch and provide liquidity in this time of crisis. However there is lot of uncertainty among the investors as they don't know who is involved in the subprime mortgage market and the investment banks themselves are not very clear about how deep they are in this crisis. The rating agencies have rated the mortgage related securities/bonds at abysmally low value and thus the prices are depreciating with no buyers. It will take at least three more quarters to understand the full extent of the subprime crisis.
-Mayank
What is Subprime? Subprime literally means 'relating to (or for) people with a poor credit rating', that is for people who have been defaulters in the past or who don't have enough healthy assets to keep as mortgage with the lenders. These people cannot procure money from the prime market.
A market is called subprime market when the money lenders give money to people without verifying their credit rating but at higher rate of interest (than the prime market) in order to earn greater profits. In the early part of this decade, the U.S. economy was doing well and people had cash and the will to spend. Also the positive feeling in the financial industry (also known as the Wall Street) and a rosy picture of the US land market by rating agencies was a boost for property market and the associated bonds. Hence people were ready to spend more than they could possibly earn and so procured loans from banks and other firms. The property rates in U.S. were increasing at a fast rate and no one wanted to miss the opportunity. People took multiple loans from subprime markets keeping (inflated) property as mortgages to invest further in house market thus increasing the property prices even more. They were happy as they could see their investment soaring and making money for them.
How did the crisis start? The subprime crisis surfaced when people started defaulting on the loans. This was inevitable because these loans were given without proper checks to people without jobs or assets. The banks confiscated their houses and started looking for buyers to recover the money. When this started happening, it triggered a vicious circle. Now people were not finding it easy to get loans as easily as before and so there were few buyers in the inflated property market. Thus the prices started falling (less demand and more supply). The decrease in the property rates meant a decrease in the value of the houses owned by borrowers and hence that of mortgaged houses with the lenders. There were more defaulters pulling the property rates further down (a decrease of more than 8% average) hurting the market even more.
How did the subprime meltdown spread and gain such big proportion? The banks who gave money to the mortgage lenders and bought these loans were supposed to scrutinize the loans. But they did not care about late payments and early defaulters as the risk was divided among investors through the sale of resulting bonds and securities that were sold to investment firms, hedge funds, mutual funds, etc. by the banks. (The securities are called RMBS-Residential Mortgage Based Securities which are further sold as CDO-Collateral Debt Obligation).
The participation of investment banks, hedge funds and mutual funds in subprime mortgage led to a spread of the losses among the investors which resulted in a credit crunch in the US market. Investors started loosing faith in the market and went on a frenetic selling spree leading to a drop in the share prices of almost all the sectors. Thus money has been sucked out of the US market and this credit crunch is the reason why experts are predicting a recession in the whole US economy. Big investment banks and lenders have subprime writedowns in Billions of dollars. The worst-hit so far are Citigroup and UBS. Goldman Sachs and Lehman brothers are the rated investment banks with minimal presence in the subprime mortgage market (as of now) and are speculated to be eying this meltdown as a good investment opportunity (this it self can be discussed at length).
What is being done to contain the damage? The Federal Reserve (America's central bank) has been trying its best to avoid a full blown recession by decreasing the interest rate at a pace unprecedented in its history. The latest cut was been done as recently as 30th Jan by 0.5 % points to reduce the interest rate to 3% (the short term interest rate has fallen by 2.25% since Aug 07) in order to avoid credit crunch and provide liquidity in this time of crisis. However there is lot of uncertainty among the investors as they don't know who is involved in the subprime mortgage market and the investment banks themselves are not very clear about how deep they are in this crisis. The rating agencies have rated the mortgage related securities/bonds at abysmally low value and thus the prices are depreciating with no buyers. It will take at least three more quarters to understand the full extent of the subprime crisis.
-Mayank
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