Correction in global equity markets due to sub prime lending crisis in US

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.

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2 comments on “Correction in global equity markets due to sub prime lending crisis in US

  1. StandingTal says:

    Hi, Ashmu . . .

    I played online chess with you a couple of hours ago at GameKnot, and I said I would visit your blog. Well, here I am. I have read quite a bit of your blog, and I can see that it has much substance.

    Regarding the credit crisis in the US, I can tell you that part of this crisis stemmed from a situation where housing prices were booming for several years. This excitement led many people to think that they could “buy” a house in a growing market, pay only the interest on their loan for 2 or 3 years, and within that span, sell the property for lots more than they bought it for. This was called “flipping” the property.

    Some lenders co-operated in this frenzy by offering loans that required payment on only the interest for the first 2 or 3 years, but after that, the borrower would have to begin paying down on the principle of the loan, in addition to the interest. This made the borrower’s monthly payment jump big-time, but only after the “grace period” of 2 or 3 years. In this way the borrower could potentially leverage their low initial investment, and make a bundle of profit. This worked during the boom. Many speculators made a lot of money doing this.

    However, as in most booms, there was an end to it.

    When that time came, the borrower(s) found that there was no longer a long line of potential property buyers trying to outbid each other to buy their property. At that time, the borrower — who knew at the outset that they could afford to pay only the monthly interest on the loan — began to be in trouble when the short-term “interest-only” provision of their loan ended.

    At that time, the borrower had to begin paying down on the principal of the loan, in addition to the interest. Well, the “honeymoon” was over, and many “flippers” (who should have known better) realized they could not afford those payments. They never had any intention of having to make those payments, because they thought that they would have sold the property before then.

    But since the demand dried up, there were no buyers, and the price(s) of the property went down — often down below what the borrower originally agreed (via the mortgage) to pay for the property. This was a big problem, because the borrower never expected to ever have to pay on the principle of the loan. He felt he would have already “flipped” the property before the time when the mortgage required that he start paying on the principle of the loan.

    When borrowers such as this began defaulting on their loans, the lenders who granted these loans started to be in trouble. That’s when the domino effect began. Other companies (as you have described in your blog) bought some of these loans, so it was no longer only the problem of the original lender.

    Things are still shaking out and nobody knows the future for sure. Personally, I think it will eventually blow over, like all the other many crises and boom-bust cycles that have occurred for 2 or 3 centuries in Europe and the US.

    — StandingTal

  2. Thank you standing tall!!

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