Subprime is Wall Street‘s euphemism for junk. Andy Serwer and Allan Sloan:, TIME, Sep. 18, 2008
How did it start?
I am confused with the current econmic turmoil (I m with George Bush on this 🙂 ) . So lets try to unwind the whole crisis. What is Sub Prime Lending? In US individuals with bad or limited credit history (or job history) find it difficult to get loan at normal market rates. Some institutions provide loans to such borrowers at a higher than normal (Prime) rates since it is a higher risk loan. There are other stringent terms and higher fee for such loans. Technically, the Subprime Loans do not meet the Freddie Mac (FNMA or Federal National Mortgage Association) guidelines.
The Risk Vs Reward dogma of the financial world is the underlying principle behind Subprime Lending too. Post 2001 economic recession, the home valuations rose steadily. This lead many people to invest in Real Estate through loans and mortgages. The Subprime Lending also rose significantly as the Lenders expected the Real Estate to go up and this secured their investment even if the borrower fail to repay. For the Borrower too this was a great oppportunity as , with Real Estage prices going up, after a period of time they could refinance thier loan at the mainstream rate. The borrowers were so illusioned by the rising property value that they accepted highly difficult to meet conditions for sub-prime mortgage. During 2005, the housing bubble got burst and Real Estate prices started seeing corrections. The borrowers started seeing downtrend in valuation of their property and refinancing became difficult. Suddenly the number of mortgage default rates increased and spiralled out in 2007-08. The Mortgage lenders took the hit and major lenders got knocked down. Owing to Securitization, the lenders had passed on the risk to third party investors via Mortage-Backed Securities and Collateralized Debt Obligation. So the subprime shock was passed to these investors (Corporates, Institutional Investors, Individuals) and they suffered heavy losses since the underlying mortgage asset value declined. Stock markets across the globe tumbled down as a result of these affected investors pulling out. Moreover, credit market saw tightening and it becomes difficult to get credit in such times. Loans for average borrowers becomes impossible and even the reputed ones have to pay higher rates. Demand goes down, growth is affected and recession sets in.
Who is responsible and What is the fix?
As a number of Banking and Investment Giants have started to fall on the ground, the US government has jumped in fire-fighting with a whopping $800 billion rescue package. The US administrations effort to stop the economic bleeding looks highly warrented to prevent collapse of economic machinery and unemployment (in short the Great Depression) . But is the rescue package a definite solution? Who is the real culprit and who should pay for this mess? The reckless lending by banking institutions and risky borrowing by financially unstable individuals has brought down the entire system. From my perspective the Banks behaved irresponsibly, their reckless practices’ have to take the blame. The Government is financing the irresponsible guys with all hard earned money of tax payers. For years, US has considered Capitalism as an unquestionable trading method. The economic instruments in US have an absolute free hand and there is no regulation. All because of a false pride on the free market. And floating this bail out package sounds like US is taking a leaf from Marx’ book and adding a flavor of its own to it. It would be appropriate to call this package policy as – Socialism For The Rich. I consider the US administrations attitude as hypocrite in this regard.
The bail out package is a short term rescue which would bring a short upswing and then system would tumble more drastically. Because the fundamental problem would still be unadressed. How justified is the exorbitant participation by banks in Real Estate Lending when Real Estate is one of the most unstable asset in terms of value? Somebody needs to define the boundary and it is imperative. Few ambitious decision makers at the helm of the banking system should not be given free way to squander the tax payers hard earned money to clean up the toxic debts.
How far would it go?
I feel the after effects of the damage has just started to appear. There is more pain in the pipe. The turmoil in US is just the beginning. The world economies are tightly integrated and that means the subprime infection is bound to spread to other countries. The pain would soon spread to EU & BRIC countries. Moreover, EU has no room for bail-outs as the concept is against the EU framework. It would be interesting to see the if the EU model really helps the constituent countries to tackle such a crisis. The BRIC Economy would undergo the Litmus test. Among the BRIC, those countries which really hold value for the future would emerge stronger after the crisis is over and it would be really interesting to see if they come out stronger enough to take on the US hegemony. I would certainly put my money on Russia and India.
Binny George's Commentary and Observations 