22-05-2012, 12:01 PM
What is sub-prime mortgage crisis
1. In US, a boom in the housing sector was driving the economy to a new level.
2. A combination of low interest rates and large inflows of foreign funds helped to create easy credit conditions where it became quite easy for people to take home loans.
3. As more and more people took home loans, the demands for property increased and fueled the home prices further. As there was enough money to lend to potential borrowers, the loan agencies started to widen their loan disbursement reach and relaxed the loan conditions. Many people with No Income, No Job, No Assets were given housing loans in disregard to all principles of financial prudence.
4. These types of loans were known as sub-prime loans as those were are not part of prime loan market (as the repaying capacity of the borrowers was doubtful).
5. Since the demands for homes were at an all time high, many homeowners used the increased property value to refinance their homes with lower interest rates and take out second mortgages against the added value (of home) to use the funds for consumer spending.
Bubble that burst…
6. Overbuilding of houses during the boom period finally led to a surplus inventory of homes, causing home prices to decline beginning from the summer of 2006.
7. Once housing prices started depreciating in many parts of the U.S., refinancing became more difficult.
8. Home owners, who were expecting to get a refinance on the basis of increased home prices, found themselves unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.
9. Since, the interest rate charged on subprime loans was about 2% higher than the interest on prime loans (owing to their risky nature) lenders were confidant that they would get a handsome return on their investment.
10. In case a sub-prime borrower continued to pay his loans installment, the lender would get higher interest on the loans. And in case a sub-prime borrower could not pay his loan and defaulted, the lender would have the option to sell his home (on a high market price) and recovered his loan amount. In both the situations the Sub-prime loans were excellent investment options as long as the housing market was booming.
11. Major investment banks and institutions heavily bought these loans (known as Mortgage Backed Securities, MBS) to diversify their investment portfolios.
12. When the prices of houses started falling and the credit borrowers could not repay it led to the downturn of the economy with the collapse of Bear Sterns, one of the world’s largest investment banks and securities trading firm. Bear Sterns was bought out by JP Morgan Chase with some help from the US Federal Bank (The central Bank of America just like RBI in India)
13. The crisis has also seen Lehman Brothers – the fourth largest investment bank in the US file for bankruptcy.
14. Merrill Lynch has been bought out by Bank of America.
15. Freddie Mac and Fannie Mae, two giant mortgage companies of US, have effectively been nationalized to prevent them from going under.
16. Reports suggest that insurance major AIG (American Insurance Group) is also under severe pressure and has so far has taken over $82.9 billion to tide over the crisis.
17. a loss in the net capital of banks meant a serious detriment in their capacity to disburse loans for various businesses and industries.