Sub Prime crisis has shocked the whole financial world during financial world 2008-09 and led to one of the worst financial crisis in the history. Due to its severe impact, some big companies like Lehman Brothers and several small companies went into bankruptcy and government had to bail out some big ones like AIG, Citibank, Morgan Stanley etc. It has also led to recession in the whole world and the impact was so big that the world is still struggling to gain the growth momentum back.
It’s not easy to understand the reason and nature of the whole crisis due to its complexity and spread across the world, but we will try our best to put into simple words so that anyone with minimum finance knowledge can get a clear understanding of the whole crisis.
For the analysis we will use some important terms that we will try to explain in detail; they are sub prime lending, Mortgage, Credit default swap, securitization, mortgage backed securities and collateralized debt obligation etc. We will try to cover all these topics in this article.
Prime lending rate is the rate at which the banks give lending to customers with normal and good credit rating for any house and other thing buy. The interest rate is driven by the credit rating of the customers. The sub prime lending refers to the lending to the customers with poor or bad credit rating with much higher interest rate than the normal prime lending rate. The down payment stayed at around 2% with nearly 40% borrower did not pay any down payment as well. With almost no down payment and high interest rate, the risk involved in sub prime lending was very high. Another facilities provided to the sub prime borrowers is the adjustable rate mortgage, by which one mortgage plan can be replaced by a new one with favorable interest rate.
Before the crucial financial year 2006-07, theUShousing market has witnessed a dream run for couple of decades, where house prices were increasing continuously. Between 1997 and 2006; theUShouse price was increased by around 120%. There was a belief that housing price would never fall down and everyone can make money out of it. TheUSbanks had also started taking advantage of the continuous price up move with more lending.
They have started giving mortgage loans to the sub prime customers with very bad credit rating at much higher interest rate only to get the benefit out of it. All the people in US have started taking mortgage loans to buy house to make profit out of the increase in the house prices. TheUSlending rules were also providing support for the same. As per the rule, if someone gets default on the same, the banks can only take the house back without any other penalties. So in case of default, the people will only loose the house they have bought with very high rate. Also the refinancing of the existing loans was available at much cheaper rate by using the adjustable rate mortgage. The mortgage market touched as high as USD 10.6 trillion in mid-2008. The mortgage qualification guideline was changed in which proof of income and employment was not a required parameter, only some amount in bank account was enough to get the huge amount of mortgage loan. The mortgage underwriting standard declined considerably and brokers has started using automated underwriting approval process without verifying the details properly. In 2007, around 40% of the total mortgage loans were approved automatically by the system. The main aim was to increase the lending and make huge profit out of it. The standard and risk management was left on the paper only.