The real estate boom, which is now the real estate bubble since it has burst, has led to the biggest financial crisis the world has seen since the Great Depression of the 1930's. One thing is certain. This is not an American problem. It is yet to show its full strength. The avalanche is far from over.
First, lets clarify a few things. What does the term sub-prime mean? What does prime mean? Simply put, prime is the ability of the borrower to repay his loans. Sub prime are those who may not be able to repay their loans.
How do banks usually give loans? They would check if the borrower will be able to repay his loan based on certain criteria and documents like salary slips, bank acounts, collaterals( some assets which can be sold by the bank if you do not repay the loan) and sureties.
Now, let me try to explain what exactly happened in the US Sub-Prime crisis.
Fine. I am really sorry for the pathetic daigram I have drawn. I hope its legible atleast to the point of deciphering what is written.
Where did it all start?
Sub prime loans. The real estate boom started around 2001 and lasted till 2006 when it burst. Everyone wanted to be a part of the party. Banks for their part were ready to lend money to those who were sub prime too. That is, people who didnt have salary slips, bank accounts, sureties or collaterals. However, they wont actually own the house till they pay the money back to the banks. These banks are the housing mortgage banks like Freddie Mac, Fannie Mae and Indy Mac all of which are no more. Why did they take this risk of Sub-prime loans? The biggest reason is that real estate was booming. They could sell the houses if the loans are not paid. The other reasons are they could impose higher interest rates and they had to deal with acute competition.
To get a clear understanding, please look into the diagram that I painfully drew.
After the apparent house owner requests for a loan and the loan is granted, the money is paid to the house developer. Where do these banks get their money from? Here is where the Investments Banks, self-proclaimed Masters of the Universe till weeks before, come into the picture. They provide the money to the mortgage banks like Freddie Mac. Lets know the distinction between normal Banks and Investment Banks. IBs generally do not give out loans to anyone. They give out loans only when the borrowers are big companies or in general, when the borrowers borrow really lots of money. Those who invest in IBs are not assured of returns. They may get higher or lower returns. Its a risky business.
IBs have provided the loans to the mortgage banks which has reached the developer. Now, where do the IBs get their money from? Now come the relatively unknown Debt Funds. The Banks in this scheme of things are Washington Mutual which tanked few days back, Citibank, HSBC, our own ICICI and hundreds of companies all over the world. Thats why I said that this problem is not pertinent to the Americans. This problem was created by the Americans and it is going to affect the whole world. Where do these Debt Funs get their money from? From the common man. These include the EPF(Employee Provident Fund), PPF( Public Provident Fund) etc.
All seems to be fine.
Where did the problem start? There would not been any problems if all the people who borrowed repaid. These Sub-prime borrowers naturally defaulted in their payments. They literally packed their bags and left overnight without repaying the money. Now lets see how prices of commodities increase or decrease. It all depends on the supply-demand ratio. If you have a pen and many people ask for it, you ll sell it to the one who pays most(Supply Now, since the borrowers did not repay their money, these banks tried to auction their houses which further increased the supply lessening the price. So, an house mortgaged for 1 crore could be auctioned or sold for only 10 lacs, a 90% loss. So the mortgage banks could not repay the investment banks who inturn could not repay their debts to the debt funds. So, first, the mortgage banks fell followed by IBs, Lehmann Brothers, Bear Sterns, Meryll lynch etc. Where does AIG come into the picture? It is the American International Group, the largest insurer in the US, and once the 18th largest company in the world. All these IBs had insured with AIG. So AIG had to compensate a lot of companies with billions of dollars. Overnight, it accrued debts of $60billion, which translates to over 240000 crore Rupees. Feel the magnitude? Next, the Debt Funds which are also banks have started to full, the most notable being Washington Mutual. Many more companies have invested here and the picture will become clearer and worser in the days to come. So, who are the people insulated from the crisis? The housing developers and those people like Warren Buffet who quit the scene when they sensed danger. A lot of mistakes have been committed. Can these banks and their CEOs held responsible? Sadly not. Because that is what limited company means. When there is the word limited in the name of the company, it means that the management cannot be held responsible for their actions. Thats it. I have tried to tell you as clearly as I can of what little I knew. You are free to comment and criticise. Bye
