Subprime crisis and capital markets meltdown...

Past few weeks have been severe on global financial markets and as we all know root cause of this mayhem is sub-prime loan. But before we could go into details its worthwhile spending some time on understanding what is sub-prime loan and how it is originated.

In US if a consumer wants any kind of loan eg. car loan, house loan etc , he first need to go through credit check. Credit check is nothing but a numeric value which indicates how much credible you are in terms of paying the loan back. So for example two consumers A & B approach Bank for loan of USD 5000 and A's credit score is 400 and B's 450 (just imaginary number taken) . Since B's credit score is higher than A's , that means B is more credible and there are less chances that he will default on the loan repayment. So in this case B might get the loan at lesser interest rate and A will have to pay higher interest rate as he is less credible (as per his credit score) . So credit score plays a vital role in any kind of loan transaction.

After dot com burst and 9/11 attack US economy was lymping, as people were less willing to spend. US being a consumer centric economy , its growth is closely tied to people spending their money. So in order to give boost to US economy, FED cut the interest rate to 1-1.5% . Since interest rates were very low, credit was very easily available to every one. So much liquidity available with banks, people started taking loans for every small thing.

It all begins with an American wanting to live the famed American dream. Since credit is cheaply available so he can fulfill his dream of having a nice house. But not everyone will have good credit score, which means even though the credit is available consumer with bad credit score will not be able to avail this loan. From here the drama starts, it has three main characters

A - Consumer with bad credit score who wants to take the housing loan
B - a Financial institution with good credit score and willing to take some risk.
C - Bank the lender which originates the housing loan.
D - Institutional investors, investment banks.

A can not get housing loan from C because of his poor credit score. B has good credit score and can easily get loan from C. B sees this as opportunity to make quick money. So he takes huge amount of loan from C at lets say X% interest rate. B then divides this loan into smaller loans and gives them out as home loans to people like A at (X+Y)% interest rate. This new interest rate is called sub-prime rate and this market is called sub-prime home loan market.

Now lets try to understand B's strategy here. As B is big financial institution and willing to take risk. On every sub-prime loan given he make Y% as the profit. Since these loans are risky as some people might default. But even if 5-10% people like A default on their EMI, B will still be seating on huge profit. But story takes a U turn from here. B does not stop here, he does not wait for people like A to pay the principal plus interest so that he can pay back C (the Bank). B goes ahead and securitises these loans . Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These securities are then sold to D (FII or Investment banks) and principal, interest paid by A is passed on to D. So this way D also make good profit from these securities backed by mortgage loans. B passes the money received by selling securities to C (the Bank) , thereby repaying the loan. Now B can take more loan from C securitise them and sell to D. There by creating continuous flow of money. These sub-prime loans were given at floating rate, which means if interest rate increases in future then monthly EMI paid by people like A will also increase which might lead to defaulting the loan.

By late 2006 interest rates started to rise. People like A who had taken sub-prime loan had to pay more now for monthly installment. Since there had unstable income so lot of people started defaulting, leading to losses for Institutional investors like D.Housing bubble was about to burst and B had major contribution to this burst. To make quick money they relaxed lending terms & conditions and gave loans to people with poor credit history. As more number of consumers started defaulting on home loans, this meant huge amount of losses for these Investment banks,FII's . These institutions failed to manage their risk properly and wiping out their net worth.

FII's & IB's generally spread their investments all over the globe to diversify their investments. FII's maintain some fixed portion of their investments in markets globally like China,India etc. So when their investments turned bad in US, to maintain the asset allocation they pulled out their investments from emerging markets like India where they were sitting on huge profits. Thats the reason why in Dec 2007 Sensex crossed 21k and now struggling to maintain 13k and USD strengthened from USD/INR=38 to USD/INR=47. Will explain this in next blog................

Credit crunch in capital markets....

I am pretty sure everyone would have come across this jargon while browsing on internet. I knew what does it mean, but never actually thought what leads to this and how does it impact capital markets. Now as capital markets are melting globally there was a need to delve into details.

Credit crunch occurs when there is lack of funds available in credit market, making it difficult for borrowers to borrow money. Credit crunch can severely impact economic growth of a country.Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible and in some cases, companies will need to cease operations.

All said and done next big question is what leads to credit crunch....

• Increase in capital requirement for Banks - Many banks and lenders are required to maintain minimum capital liquidity based on their assets. This capital requirement is regulated by regulatory bodies in the respective countries (in US FED). So if FED increases the capital requirement then lenders need to increase the capital reserves, left with less cash to lend to borrowers hence leading to credit crunch.

• Increase in lending/interest rates - To curb inflation regulatory bodies tend to increase the lending rate, so that it will cost more for the same credit. So people will take lesser number of loans. This again leads to credit crunch and may hamper the growth of economy.

• Greater risk in market - If bank sees there is risk involved in lending because of adverse market conditions or poor credit history of the borrower. Bank can increase the lending rate to offset the risk its taking. This increases cost of borrowing and makes borrowing more difficult.

Now we know what is credit crunch and what leads to it, next i would like to discuss about Credit default swaps which played a key role in AIG,Freddie Mac downfall........