Nothing prime about it!

Very often do people speak or write in a language that it becomes impossible for someone unrelated to the industry to understand a concept, a phenomenon, a process or an event. Sub-prime crisis as they call it as, is arguably one such one. It is too simple to understand the logic but too complex is the entire chain of its operation.

Just forget why Lehman, WaMu, Wachovia is falling. Try answering this question. Who do you think lends you money when you take a home loan? The banker? Yes, you are mistaken. How would it leave a taste on you, if I would say it is me, a common man who is indeed lending my money to you, when you take a loan from bank?

Now, this is the chain. You apply for a loan to a bank, which tenders you, money. Your bank is in-turn funded by an Investment bank, the big daddy of US economy, for exchange of your loan document. These I banks collates all such loan document from different people and different banks and creates a bond (called Real Estate Investment Trusts -REITS). These bonds are finally issued back to common people like me, who wish to invest in such bonds, which are now called as CDO (Collateralized Debt Obligation) or ABS (Asset Backed Security). So in this vicious cycle, I, your neighbor could possibly end up being your lender, notionally, when you apply for a home loan.

So, why does all these I banks fall off? Now, to put it as mean as possible, if you earn 10,000 Rs per month and pay 5000 Rs as an EMI, it is a prime loan, whereas when your EMI is 9000 Rs on a 10,000 Rs monthly salary, it is a sub-prime loan (relate to the fact that in India we have PLR- 'Prime' lending rate). When the credibility and capacity of the borrower to repay loan decreases, the interest rate on loan increases since the risk is perceived higher by the bank. So, someone with a good credit rating will be offered a prime loan at say 8%, the other person with low credit rating will be offered a sub-prime loan at say 10%. It’s a double whammy for sub-prime borrowers – lower disposable income and higher interest rates. Hence, a small increase in interest rate would shatter sub-prime borrowers capacity to repay and he begins to default on his EMI payments. It all starts here. Non receipt of EMI means your lender banks cannot pay back their EMI to I banks, means the I banks cannot pay back the investors who had invested in their bonds. Now, bank in their helplessness try to sell out the house (Foreclosure) - the distressed property of its borrower to recover their lent out money. But due to adverse market conditions, the inflated market value of the house had dropped like a stone. Hence, the recovered money is at a huge discount to the lent out money. The I banks are at great pressure to pay back investors and the money they have is less – the stage is set up for the closure of business. The entire financial juggernaut comes to a halt as it has done now.

US banking industry thrived on converting a loan into a tradable paper and leveraged too much on it, to the levels that now a house is available at as low as 72,000Rs. Back India, thank that we are still very slow in implementations largely due to our democratic set up that we did not copy US in CDOs and REITs just in the exuberance of consumerism.