US Sub-Prime Crisis - Simplified

·         The word ‘Sub-prime’ means a borrower of very low credit worthiness like borrowers with very low income or with bad loan repayment history. Mortgage or Home loans given to sub-prime borrowers are called sub-prime mortgages.

·         From year 2001 to 2004 USA Federal Reserve cut interest rates drastically to boost the economy after recession in 2001. This led to availability of easy & cheap money and this created subsequent boom in Housing Market/Real Estate as people utilised cheap credit to buy homes.

·         Everybody was convinced at that time that home prices would keep on rising every year. Banks and Financial Institutions started considering Home Loans as safe loans thinking that ever rising prices of homes would be sufficient to cover Home Loan and interest.

·         Due the this confidence Banks started offering Home Loans to sub-prime borrowers who would not have otherwise eligible for such loans. Banks were happy as they were able to charge higher interest rate to such borrowers. Borrowers were happy as they could get loans easily. Home prices got further boost due to such loans.

·         Most of these loans were repackaged as bonds and sold to investors all around world. These investors include banks and financial institutions who purchased such instruments to get higher returns. Now it is very difficult to precisely quantify the total losses suffered by all investors.

·         Federal Reserve started increasing interest rates from 2004 to 2006 and simultaneously Home prices started declining.

·         Suddenly borrowers realised that they had to pay higher interest on their old loans while the homes they own were losing value on regular basis. Many started defaulting on repayments.

·         Banks found it difficult to recover the loans as they noticed that value of Homes were much below the loan amounts given by them. They have to make huge provisions for losses.

·         Investors around the world who invested in these loans/bonds suffered huge losses.

·         Risk Aversion - Foreign Institutional Investors started withdrawing their investment from countries like India to compensate for their losses at home and to reduce the risks associated with their investments.

·         Credit Crunch - Financial Institutions reduced the number/amount of loans sanctioned by them.

·         The whole development caused home prices to further fall and started a vicious cycle were financial system all over the word got further affected resulting in global slowdown in growth.

·         Federal Reserve tried to fight the problem by reducing the interest rates, but this caused commodities Bull Run and inflation. Some of the financial institutions fail and borrowers, Banks, Investors keep suffering.

·         It is not easy to quantify the extent of losses/write offs and time required for financial systems to recover from this crisis. USA and Europe are the major regions affected. Emerging markets like India suffer indirectly thru Risk Aversion by global investors, global slowdown, inflation, credit-crunch (non availability of funds for companies).