Macro Moves

Everything about Subprime Home Loan Crisis

Created on 18 Mar 2020

Wraps up in 5 Min

Read by 1.7k people

Updated on 30 Jun 2020

Subprime loan crisis
Loans have proved to be the critical aspect of any economy. It acts as a bridge leading to the unreachable needs and impossible dreams. The doors of the bank would be the first thing we would be knocking once we run out of options. Whether you wanted to buy a new home or finance your educational goals or any of your need for that matter. But one cannot ignore the fact that the same loan has laid the road to recession in the past. 

Recession is something we continuously hear about nowadays. But the 2008 recession hurt the United States economy more than anyone thought. The subprime loan crisis was not only the root cause of the recession but also buried the housing dreams of millions of Americans. 

So let me take a tour around the facts about the subprime loan crisis and how it impacted the world. 

What is a subprime loan? 

Irrespective of which loan you wanted to obtain, your credit rating will decide whether or not your loan will be sanctioned. Credit rating depends upon factors like your history, discipline in paying back your credit, how reliable you are, will you be able to pay back the loan or not, etc. In India, anyone who is going to apply for a credit will be checked for their creditworthiness. A CIBIL score acts as a tool which rates a person based on their repaying ability. After which the loan is sanctioned to individuals who hold a good rating. Anything above 700 is considered good, and the person is assumed to be reliable.

Similarly, a decent FICO credit rating is required to get a loan from a US bank. It would help if you had a score of 640 or more to get your loan sanctioned. But anything below that will make you ineligible for obtaining a loan. 

However, the subprime loans were concentrated on people with poor credit ratings. That is below 640. Bankers consider these loans as risky and thus charge a higher interest than a typical mortgage. The housing sector was also at a boom. So the subprime loan happens to be a win-win for both the banker and customers.  

These loans are generally Mortgage-Backed Securities (MBS). That is the entire loan amount bundled up and divided into small shares called tranches. These tranches are brought by individual investors, corporates and commercial houses. Investors are paid a dividend out of the monthly instalments made by the borrowers. Attractive returns slowly captured the attention of investors including some big fishes. 

MBS are derivatives which get their value from an underlying asset. These MBS are sold at secondary markets just like any other securities. As an investor, you will be buying security which is equivalent to the value of a loan or part of it. 

The customers mortgaged their properties which they brought to obtain the loan. In the event of failure to repay the loan, the bankers will sell it at a higher rate, and both the investors and bankers will see a profit in this process. This is because the housing sector was at its all-time high, during that period.

 Brewing up of the catastrophe 

The primary cause of the crisis was sanctioning of too many mortgages to selling their corresponding Mortgage-Backed Securities in the secondary market. In 2004 the housing sector climbed the ladder of growth at a faster rate and was favouring the act of the bank.

But soon the prices fell drastically. The risk of default and bad loans were distributed to the securities, derivatives and mutual funds. This affected the investor sentiments. The Fed anticipated a possible crisis and took steps to stop it. It increased the interest rates from 2.25% to 5.25% by the middle of 2006. Their objective was to shrink the number of people demanding a subprime loan and also keep a check on inflation. But the crisis hit despite the actions of the Fed. By the end of 2007, when the price of houses started to fall, the customers who borrowed loans began to feel the pressure of the increasing interest rates. The investors who invested in the tranches started losing faith in it. 

The beginning of the recession 

In order to compensate for the loss of bad debts, the banks went on increasing the interest rates. The cases of people who failed to pay back the instalments went on piling up and the value of houses depreciated mostly. Following this, a lot of banks and investors struggled to cope with the losses sustained as a result of their investment in MBS. Further, plenty of banks filed for bankruptcy. 

The Lehman Brothers were also hit by the housing bubble burst as they based a lot of their investment activities on the subprime mortgages or MBS. One of the largest investment banks, the Lehman Brothers, filed for bankruptcy by the end of 2008. The US economy officially entered a recession. The recession caused a domino effect throughout the US economy. Unemployment started growing at a constant rate. And a lot of families, mostly those belonging to the middle class lost their homes. The share markets crashed. The economies around the world were also injured. 

Did it impact India?

At that time, India was less dependent on the United States in terms of exports. The Indian banks were also less involved or exposed to the US securities. As the Indian GDP was mostly driven internally, the recession had less effective than expected. 

Yet, it never failed to expand the fiscal deficit and the current account deficit. The budgetary deficit roughly intensified from 2.7% to 6% during the financial year 2008-09. So the government was forced to incorporate specific measures or policies to deal with it. Further, the value of rupee against US dollars fell sharply. The banks suffered because of the sharp increase in CAD, which led to a rise in non-performing assets. 

The recovery wasn’t a smooth process either. Americans and the entire world were spectators of what a recession could do to an economy. No country would want to experience such a situation again. With Corona taking control over the economy, let’s hope that it does not give way to another recession. 

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Ayushi Upadhyay

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A Keen Learner. Tiny, brainy, and studious, this quiet one stays in her zone until she pops. And once she does, boy, are her comebacks snappy! There is no financial question that she can't answer through her magical blog-writing. 

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