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Wednesday, August 12, 2009

Subprime Crisis In A Nutshell

The US Subprime crisis (over USD 5 trillion in losses) began to reveal itself somewhere in the last quarter of 2006. It's full impact was still anyone's guess. However, soon it began gripping the global economy, toppling financial markets; setting off recession; and pushing marginal countries, like Iceland, on the verge of bankruptcy. The crisis was more a result of blind enthusiasm riding on the back of a decade long rally from mid-1990s to 2006, and utter disregard for the fundamental business cycles related to the real estate markets. The market players, during the building up of the U.S. housing bubble, seemed to carry the misplaced optimism about the rising property prices.

Driven by oil and food prices in the world markets in 2006, inflation started climbing. At the same time, the property prices started climbing on account of oversupply of built-up homes. The cost of the mortgage loans (most of which were adjustable rate loans) shot up for most borrowers. As a result, the loan to rental value ratio also began increasing considerably. The matters got worse, as a sizable number of homeowners driving the market rally, were subprime borrowers. With the rise in inflation, the purchasing power of the subprime borrowers eroded and they began defaulting on loan repayments. Since, the Alt A, or subprime loans (for the borrowers with no, or inferior credit records) carry higher interest rates than prime loans, the lenders freely offered loans when prices were rising. The U.S. Government's encouragement to subprime lending, especially through its sponsored organizations, Freddie Mac and Fannie Mae, added steam to the then rallying markets. The highly developed secondary mortgage market and its inherent financial engineering techniques fueled the crisis further. Investment banks and other financial institutions repackaged the mortgage loans as MBS (Mortgage Backed Securities) or CDO (Collateralized Debt Obligations), thereby maintained money supply for further lending, apart from taking large exposures in such securities.

Year 2007 started on a grim note of an impending possibility of an approaching financial turmoil and by mid-2008, it became clear this predicament would not remain limited to the US. The fall of 158 year old Lehman Brothers triggered a chain reaction world over – the leading institutions at the Wall Street were wiped out, the world stock markets crashed, the credit lines froze, the business activities dipped and there was an overall liquidity crunch.

Eurion Constellation is a research and consulting firm serving businesses in U.S., Europe and India. The research services have a global reach with focus on industry / market / economic research, financial analysis, equity research, company valuations and report writing. The consulting wing in India focuses on the startup and SME sectors. Please feel free to get in touch for any business requirements. Visit http://www.eurionconstellation.com

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