What is subprime effect?

Last updated: 18 September 2007

What is this subprime effect? By - Ashutosh M Wakhare If you are the kind who follows the business press and news channels very closely, then chances are that, in the last one week, you would have heard stock market experts blaming US subprime defaults for the fall in the Indian markets. Welcome to the world of globalisation, where when America sneezes, India catches cold. But what on earth is this subprime crisis? It all starts with an entrepreneur who finds a demand-supply gap between people who want to buy a house and people who have the money to lend. These people who want to buy a house do not have a good credit rating, i.e., their probability of defaulting on the loan repayment is very high. So, if anybody wants to lend money to them, it will have to be at a significantly higher interest rate (sub-prime rates is the jargon for it). This is because the entrepreneur lending the money is taking a higher risk, and hence, needs to be compensated through higher returns. The entrepreneur takes a loan from a bank/ investment bank at low interest rate (as he has a good credit rating, he can raise money at competitive rates) and lends out that money to many people at a higher interest rate. This ensures that he gets a higher return than what he pays on the loan. At the same time, by giving out loans to many people, he has ensured that a few defaults on repayments do not have a huge impact. (This part is depicted by the fluorescent green arrows in the chart) Another key feature of these loans is refinancing. The loans are such, that in the first 2-3 years, the interest rates are very low and then they become variable (which means they will become volatile and can go up significantly) for the remaining term, usually 27-28 years as the loans are generally for 30 years. When real-estate markets are booming, refinancing is not a big problem. Every two years, the borrower gets to refinance his loan, thereby his cost of loan never really goes up. The entrepreneur, on his part, securitises the loan by issuing mortgage-backed securities (MBS) i.e., he divides his loan into marketable financial securities and sells them to investors. The investors are promised a certain rate of interest on these securities. The money collected by securitising the loans is used by the entrepreneur to repay the bank/ investment bank. (This part is depicted by the dark green arrows in the chart) The coupon (interest) payments and the repayment of principal for the investors of the MBS are met by the installments, which the home loan borrower pays every month. (This part is depicted by the red arrows in the chart) As interest rates start climbing, the impact will be felt on the real-estate market with prices flattening/climbing down. A double whammy will hit the home-loan borrowers as rates start climbing. They were not in a position to pay higher installments and when they went to refinance their loans, as they had been doing earlier, it was not possible this time around as nobody wanted to refinance when real-estate prices were falling. This lead to defaults by the borrowers (remember - their credit quality was always very poor). As the borrowers default, the repayments from the borrowers, which were used to meet the interest obligations of the securitised paper, also stops. This lead the investors to bang the doors of the entrepreneur who had issued the security. What could the entrepreneur do? He would file for bankruptcy under Chapter 11 (The red arrows get broken). Now, what happens to the investors? In case of institutional funds, all their investments would turn. Any fund with global exposure has percentage allocations to various parts of the world. So, in case the US exposure turns bad, the fund will have to pull out of all markets for keeping the percentage allocation in line with the stated objective, and also for meeting possible redemptions. IKB, a German bank, has already said that it had invested in such papers and has issued a profit warning. In fact, the issue is snowballing into a larger one, with German investors worried about other banks having similar exposure as well. Meanwhile, German banks have come together to bail out the bank even as the IKB chief executive has stepped down. Now, if this is not all, there starts a negative spiral. As prices flatten, defaults increase as no refinancing is available. As defaults increase, lending rates increase as lending is now done in a stricter manner. As lending slows, the flow of money to the sector stops even more, so prices decline still further and thus starts a cascading effect. Now, the debate is on whether this crisis will have an impact on the US economy as a whole or will the economy be insulated from this crisis? In case this virus affects the economy, one can forget support levels for our markets.and yes, you never catch a falling knife, so the best step would be to stay away from the markets. Once the storm has subsided, you can find pearls at throwaway prices!

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What is subprime effect?

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