Tuesday, August 14, 2007

Sub Prime woes

For the past few weeks the stock markets around the world have been highly volatile due to what is known as "Sub prime mortgage crisis".

I remember BusinessWeek broke the story on subprime mortgages some last year and since then one by one a lot of sub prime mortgage lenders in the US have gone bust. Here is a explanation of the issue.

What is a sub-prime mortgage: Unlike India or other developing countries the United States has a very structured credit reporting mechanism, Nearly every US resident having any economic activity has a credit history based on the his/her past record in paying the past loans. This credit history is assigned a score known as a credit score (also known as FICO score). A good credit history and score is seen as a sign of financial responsibility and gives lender a good idea of how risky a borrower is.

People having good credit histories and scores are clubbed into a category known as Prime borrowers, whereas those having a poor track record are in sub-prime category.

Obviously Prime borrowers command the best interest rates and terms from lenders for their mortgage/auto or any other kind of loans, sub prime borrowers on the other have to contend with much higher interest rates and terms, Many reputed lenders lend to only Prime market.

For the past few years the US has seen a robust real estate market, During this phase, some lenders started what is called “Predatory lending” practices to the sub prime borrowers, new exotic varieties of mortgage products like Option ARMs were cooked by these lenders. To illustrate in one variety of these mortgage products the lender would offer a introductory 1% interest to the borrower in the first year of the loan, or for the first year the borrower would have to pay only the interest part of the mortgage that too only partially, as a result unsophisticated sub prime borrowers made costly mistakes and took decisions to take mortgage loans they could have never afforded, after the initial year or so when the loan installment started going up sharply (2,3,4 times in many cases) the borrowers started defaulting on the loans, and hence this whole mess.

In the US the mortgage lenders sell their mortgages as securities on wall street and US being the financial superpower financial institutions from across the world puts money in these securities. Nobody realized that the assets behind those mortgage backed securities were such risky mortgages and this is how the whole chaos spread across the world. Even now we don’t know exactly which banks and FIs are affected.

Related articles on Bullish Indian blog:

What is sub prime lending
How does global markets gets affected

1 comment:

CVR said...

Thoroughly enjoyable posts!!
Would love to see more from you!!

Kudos and Rock on! B-)