There has been a mild correction in global equity markets for quite some time now, the roots of this correction can be traced back to the sub prime lending crisis which started in the US in 2006. Sub prime lending refers to the practice of giving a loan to a person who has had a bad credit history. For eg: a person takes a loan from a regular bank at the prevalent rate of interest but is not able to return the money in time or has defaulted payment. Now the next time he wants a loan regular banks will refuse to give it and therefore he has to go to a sub prime lender, who will give the loan at a much higher rate of interest. In short sub prime lenders give loans to people with a bad credit history.
There are several firms in the US which are into this business; New century financial corporation is the second biggest lender in the US. Now the amount of loans that these firms can give depends on the capital that they have or the liquidity or deposits which they have. Hence once a loan is issued liquidity is depleted and now for giving a new loan they require new capital, hence to raise capital these firms sell that loan which they have issued to investment banks in return for liquidity which now becomes a new loan ready to be issued. And the debtor will now re pay back the loan to the investment bank. Since the sub prime lender has sold the loan of a person with a bad credit history to the investment bank there is a risk that he may default payment of a certain amount, hence the first 5% of default payment is paid by the sub prime lender to the investment bank, this is known as Collateral debt obligation (CDO). Now the question remains what does the investment bank do with that loan?? The investment bank starts securitizing these loans, they convert it into a bond and issue it in the bond market, its a mortgage backed bond, this bond is then further converted into a derivate. Derivate is a financial instrument whose value is derived from the asset which it is backed by, in this case it is the house for which the original loan was taken.
Now the problem with this entire system is that till 2005 the number of payment defaulters in the sub prime market were 5% in 2006 this has gone to 14%. This is because of the “credit boom”, a person takes a loan under two circumstances, first when he has a good income and can afford to take a loan and second when credit or loans are easily available due to the financial system. A credit boom therefore brings those people in the loan market who earlier could not have afforded to take a loan due to their inadequate income. Because the number of payment defaulters have gone up a lot of houses have been confiscated by the banks and are up for sale. Since supply of houses is more than demand the prices of these houses have gone down substantially creating problems in the housing market. Now as mentioned earlier the loan for the house was converted into a derivate and since the value of the house has gone down the value of the derivate has also been severely affected. Hence the mortgage packed and backed security market (which includes bonds, derivate etc) has been affected and this has resulted in the correction in the stock markets in the US. It is said that when the US sneezes the rest of the world catches a cold, due to the New York stock market being affected all the stock markets in the world are experiencing a mild correction, because US is an important trade partner and a source of FDI and FII.