The Hindu Business Line : A primer on sub-prime crisis

Sub-prime lending arises due to necessity. People with bad credit history also need loans. And banks are always looking for newer avenues to make money.

Srinath Sridhar

Rama Sridhar gave a groan as the announcement came over the airport loudspeaker. The flight to Hyderabad was delayed by another two hours. It was scheduled to take off at 11 pm now. Her son Ajay — a chartered accountant, working in Hyderabad — was nonchalantly flipping through the pages of a financial magazine.

Pleasantries exchanged

Suddenly Ajay saw somebody calling out his mom’s name loudly across the airport waiting room. The middle-aged lady came running over and hugged his mom. Ajay now recognised the lady as Shalini, who was his mother’s old schoolmate. A middle-aged man standing behind her was her husband Vinod, who was working as a manager in a bank. As they all sat down, few moments were spent in pleasantries, even as Ajay got bored and got back to his book.

Ajay, lifting his head, asked Vinod: “What do you think of the sub-prime crisis? “Ajay...” began his mom menacingly. Vinod waved her to be silent, and said: “That’s ok with me. Finance is any day better than gossip.”

“Anyway, I hardly know what the sub-prime crisis is. I hear it so often on television, but it always stumps me,” added Shalini.

“Sub-prime loans, also called ‘B loans’ or ‘second chance loans’, are given to borrowers who do not qualify for market interest rates because of problems in their credit history. Borrowers who have a FICO credit score below 620 (on a scale from 380 to 850) are generally defined as sub-prime borrowers.

Sub-prime loans are generally considered risky for both the borrower and the lender. It’s risky for the lender because borrowers usually have lower incomes and a poor record for paying debt, which increases their default probability,” Vinod said.

“It is also risky for borrowers. To offset the risk of defaults, lenders charge high rates of interest. The high interest rates, however, are a strain on the borrowers, which further increases the likelihood of default,” rattled off Ajay proudly and looked around, almost expecting an applause.

“Hmm, I get it,” said Rama Sridhar. “This sub-prime lending arose due to necessity. People with bad credit history also need loans. And banks are always looking for newer avenues to make money. So they are prepared to take that extra amount of risk for an additional rate of interest.”

Vinod nodded: “Exactly. Sub-prime loans were given with the realisation that a lot of money could be made to loan takers with a poor credit history who could not get conventional loans. This opened many opportunities for sub-prime lenders to lend to people with below acceptable credit scores. Sub-prime mortgages reached a record of $805 billion in 2005. In 2006, they totalled approximately $600 billion.”

“All this talk is tiring me. Anybody wants some coffee and sandwiches?” asked Shalini. There were murmurs of assent from everybody.

Housing bubble

“So why couldn’t the borrowers repay the loans they had taken?” murmured Rama thoughtfully. Ajay immediately spoke up: “Rising interest rates, increasing the monthly payments on newly popular adjustable rate mortgages, together with property value declining as a result of housing bubble, left many home owners unable or unwilling to meet financial commitments, and lenders without a means to recoup their losses.”

Shalini came back with cups of hot coffee and sandwiches for everybody. All of them gratefully accepted.

“So what were the immediate fallouts?” Shalini asked. Vinod thoughtfully sipped his coffee before answering. “This resulted in a severe credit crunch, threatening the solvency of a number of marginal private banks and other financial institutions. The sharp rise in foreclosures after the housing bubble burst caused several major sub-prime mortgage lenders to shutdown or file for bankruptcy, with some accused of actively encouraging fraudulent income reporting on loan applications.

“This led to the collapse of stock prices for many in the sub-prime mortgage industry, and the stock prices of some large lenders also dropped. This has been associated with declines in stock markets worldwide, several hedge funds becoming worthless, co-ordinated national bank interventions, contractions of retail profits, and bankruptcy of several mortgage lenders,” said Vinod.

Shalini asked: “But why couldn’t anybody see it coming? What was the main reason?”

“There were a number of people to blame. Some have highlighted the predatory lending practices of sub-prime lenders and the lack of effective government oversight. Others have charged mortgage brokers with steering borrowers to unaffordable loans ev, appraisers with inflating housing values, and Wall Street investors with backing sub-prime mortgage securities without verifying the strength of the portfolios.

“Borrowers have also been criticised for overstating their incomes on loan applications and entering into loan agreements they could not meet or did not understand. Some sub-prime lending practices have also raised concerns about mortgage discrimination on the basis of race,” reeled out Ajay incoherently as he munched the sandwiches.

Mortgage terms

“And what steps are being taken to overcome this crisis?” asked Shalini.

“Well, everybody has to do something to tide over the crisis. Central banks have conducted open market operations to ensure member-banks have access to funds (i.e., liquidity). Central banks have also lowered the interest rates charged to member-banks (called the discount rate in the US) for short-term loans.

Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favourable mortgage terms (i.e., loan modification or refinancing).

“Homeowners have also been encouraged to contact their lenders to discuss alternatives. The media can help educate the public and parties involved.

“It can also ensure the top subject material experts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions,” drawled Ajay.

As the voice from the loudspeaker announced boarding for their flight, they got up slowly collecting their luggage.

“Mom, can I have five hundred bucks, I need to buy something,” said Ajay.

“Of course not, I never get the money back from you. After listening to this sub-prime crisis, I don’t want one of my own,” replied Rama Sridhar smartly. Ajay made a wry face as all of them laughed.

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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