Why Did Lehman Go Bust And What Exactly Is Subprime?

By | September 26, 2008

US mortgage crisis: A subprimer


Q: What is a sub-prime loan?

A: In the US, borrowers are rated either as ‘prime’ – indicating that they
have a good credit rating based on their track record – or as ‘sub-prime’,
meaning their track record in repaying loans has been below par. Loans
given to sub-prime borrowers, something banks would normally be reluctant
to do, are categorized as sub-prime loans. Typically, it is the poor and
the young who form the bulk of sub-prime borrowers.


Q: Why loans were given?

A: In roughly five years leading up to 2007, many banks started giving
loans to sub-prime borrowers, typically through subsidiaries. They did so
because they believed that the real estate boom, which had more than
doubled home prices in the US since 1997, would allow even people with
dodgy credit backgrounds to repay on the loans they were taking to buy or
build homes. Government also encouraged lenders to lend to sub-prime
borrowers, arguing that this would help even the poor and young to buy
houses.
With stock markets booming and the system flush with liquidity, many big
fund investors like hedge funds and mutual funds saw sub-prime loan
portfolios as attractive investment opportunities. Hence, they bought such
portfolios from the original lenders. This in turn meant the lenders had
fresh funds to lend. The subprime loan market thus became a fast growing
segment.

Q: What was the interest rate on sub-prime loans?

A: Since the risk of default on such loans was higher, the interest rate
charged on sub-prime loans was typically about two percentage points higher
than the interest on prime loans. This, of course, only added to the risk
of sub-prime borrowers defaulting. The repayment capacity of sub-prime
borrowers was in any case doubtful. The higher interest rate additionally
meant substantially higher EMIs than for prime borrowers, further raising
the risk of default. Further, lenders devised new instruments to reach out
to more sub-prime borrowers. Being flush with funds they were willing to
compromise on prudential norms. In one of the instruments they devised,
they asked the borrowers to pay only the interest portion to begin with.
The repayment of the principal portion was to start after two years.

Q: How did this turn into a crisis?

A: The housing boom in the US started petering out in 2007. One major
reason was that the boom had led to a massive increase in the supply of
housing. Thus house prices started falling. This increased the default rate
among subprime borrowers, many of whom were no longer able or willing to
pay through their nose to buy a house that was declining in value. Since in
home loans in the US, the collateral is typically the home being bought,
this increased the supply of houses for sale while lowering the demand,
thereby lowering prices even further and setting off a vicious cycle. That
this coincided with a slowdown in the US economy only made matters worse.
Estimates are that US housing prices have dropped by almost 50% from their
peak in 2006 in some cases. The declining value of the collateral means
that lenders are left with less than the value of their loans and hence
have to book losses.


Q: How did this become a systemic crisis?

A: One major reason is that the original lenders had further sold their
portfolios to other players in the market. There were also complex
derivatives developed based on the loan portfolios, which were also sold to
other players, some of whom then sold it on further and so on.
As a result, nobody is absolutely sure what the size of the losses will
be when the dust ultimately settles down. Nobody is also very sure exactly
who will take how much of a hit. It is also important to realise that the
crisis has not affected only reckless lenders. For instance, Freddie Mac
and Fannie Mae, which owned or guaranteed more than half of the roughly $12
trillion outstanding in home mortgages in the US, were widely perceived as
being more prudent than most in their lending practices. However, the
housing bust meant that they too had to suffer losses – $14 billion
combined in the last four quarters – because of declining prices for their
collateral and increased default rates.
The forced retreat of these two mortgage giants from the market, of
course, only adds to every other player’s woes.

Q: What has been the impact of the crisis?
A: Global banks and brokerages have had to write off an estimated $512
billion in sub-prime losses so far, with the largest hits taken by
Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half
of these losses, or $260 bn, have been suffered by US-based firms, $227
billion by European firms and a relatively modest $24 bn by Asian ones.
Despite efforts by the US Federal Reserve to offer some financial
assistance to the beleaguered financial sector, it has led to 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 Fed.
The crisis has also seen Lehman Brothers – the fourth largest investment
bank in the US – file for bankruptcy. Merrill Lynch has been bought out by
Bank of America. Freddie Mac and Fannie Mae have effectively been
nationalized to prevent them from going under.

Q: How is the rest of the world affected?
A: Apart from the fact that banks based in other parts of the world also
suffered losses from the subprime market, there are two major ways in which
the effect is felt across the globe. First, the US is the biggest borrower
in the world since most countries hold their foreign exchange reserves in
dollars and invest them in US securities.
Thus, any crisis in the US has a direct bearing on other countries,
particularly those with large reserves like Japan, China and – to a lesser
extent – India. Also, since global equity markets are closely interlinked
through institutional investors, any crisis affecting these investors sees
a contagion effect throughout the world.

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