Sub-prime loan: In the US, borrowers are rated either as ‘prime’-indicating that they have good credit ratings based on their track record-or as sub-prime, meaning their track record repaying loans has been below par. Loans given to sub-prime borrowers which banks would normally be reluctant to-are categorized as sub-prime loans. Typically, it is the poor and young who form the bulk of sub-prime borrowers.
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. The government also encouraged lenders to lend to sub-prime borrowers, arguing that this would help even the poor and young buy homes.
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 sub-prime loan market thus became a fast growing segment.
Interest rate on sub-prime loans: 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 flushed 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 principle portion was to start after two years.
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 sub-prime 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.
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 made the lenders left with less than the value of their loans and had to book losses.
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 realize that the crisis has not affected only reckless lenders. For instance, Freddie Mac and Fannie Mae which owned or guaranteed over half 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 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.
Impact of the crisis: 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 billion) and Merrill Lynch ($52.2 billion). A little over half of these losses, or $260 billion, have been suffered by US-based firms, $227 billion by European firms and a relatively modest $24 billion by Asian ones.
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. Reports suggests that insurance major AIG (American Insurance Group) is also under severe pressure and has asked for a $40 billion bridge loan to tide over the crisis. If AIG also collapses, that would really test the entire financial sector. AIG was finally supported by American Federal Bank by granting the bridge loan required.