The Subprime Meltdown

Part 1

The Subprime MeltdownвЂÑ"

Introduction

Recently, there has been a sharp rise in subprime loaning in the US, which is causing an upset in the US financial market and as a result affecting all the other sectors of business in the US economy as well. Moreover it has caused hiccups in international financial markets as well.

In the first half of the report we will take a look at what subprime loans are and how they originate, then we go on to see how it is affecting the financial market of the US and how it spread to the other sectors and affected them simultaneously. Finally we discuss the possible steps to be taken to get the situation into control.

In the second half, we see how this crisis affects other countries and how they can buffer themselves from any lasting harm.вЂÑ"

What Are Subprime Loans?

Subprime loans or Second Chance Loans are given to borrowers who have a negative credit history and cannot qualify for the current market interest rates. Subprime loans a usually risky for both the lender and the borrower. The lender is at risk because the borrowers have lower incomes and poor record for paying debts, increasing the risk of bad debts for the lender. The borrowers are at risk because the lenders would charge a higher rate of interest on the loans to secure their financial safety. In discussing this, Aaron NematNejad states “The high interest rates however are strenuous for borrowers which further increases their likelihood of default.” This means that whatever the interest rate, the borrowers are at a higher risk of causing bad debts to the lenders.

Subprime loans were created with the realization that a lot of money could be made to borrowers with poor credit who could not get conventional loans. Conventional lenders would not take the risk to lend to people with credit scores below the firm threshold. This opened many opportunities for subprime lenders to lend to people with below acceptable credit scores.

How Are Subprime Loans Created?

NematNejad explain how subprime loans are created:

“The story begins with borrowers who have a poor credit history looking to buy a house and are prepared to pay a mortgage rate typically 2% higher than rates charged to people with good credit. Borrowers approach mortgage brokers or conversely get brokers to call them. Brokers match prospective borrowers with lenders who further lure borrowers with exotic mortgages such as “no doc” mortgages, which do not require any evidence of income or savings. Big banks and wholesale lenders such as HSBC Holdings buy the debt, repackage them and sell them to Wall Street firms. Wall Street banks and investment houses further repackage these loans in Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO). These structured products very often yield high rates of return.”

Quite simply put, the borrowers with bad credit ratings get the money from willing lenders at a higher interest rate. The lenders then sell the debt to financial institutions who resell it to Wall Street firms and investment houses. It all goes according to the plan then everybody earns a big chunk of cash. But if the borrower is not able to clear the debt for any reason, then everybody loses, resulting in NPAs (Non-Payable Assets).вЂÑ"

The Crisis

The problem here is that subprime loans are relatively easier to get than conventional loans, may be too easy. Subprime lenders naturally foreclose properties at a much higher interest rate than conventional lenders. Around 3.3% of subprime loans end up as foreclosures compared to a mere 1.1% of conventional loans, according to statistics. The subprime meltdown is supposed to have started in 2006, with property foreclosures increasing day by day. Due to this, a lot of major financial institutions such as CitiGroup, Meryll Lynch, Barclay’s Capital, HSBC, Lehman Bros., Morgan Stanley and many others ran into huge losses. Some even had to file for bankruptcy.

The subprime meltdown and house prices are actually interrelated вЂ" as house prices go down, so does the equity value of the home mortgages. This will create an increase in mortgage defaults, which will bring down home prices even further. This spiral will continue until the speculators in the economy have reasons to believe otherwise. The problem will probably plague other sectors of the economy as well. NematNejad explains: “The downturn in the housing market will drag down the construction sector which will further affect other industries like plumbing, furniture and home improvements as well as Lawyers. With all this extra worries in companies, investors will pour their money in risk free treasuries. This will induce more money to be pulled out of junk bonds and loans to finance leveraged buyouts.”

Impact on the Housing Market

The slump in the stock market is mainly due to the problems in the housing market which keeps on sinking by the day. The subprime lenders loaned money to the borrowers at a very high rate of interest without any knowledge of their financial status. These mortgage loans were then sold to mortgage buyers, who would further sell them to banks and other financial institutions who would restructure these loans into Mortgage Backed Bonds or Securities. Eventually, the borrowers who took out a subprime mortgage in the beginning have their houses repossessed due to the inability to pay off the loan, which drags the overall housing market lower, not to mention the rise in NPAs for the banks. Moreover, this will affect all the sectors associated with the housing market. If the housing market goes down, it will take other market down with it like, the furniture industry, plumbing, architecture, electronics and many more.

Impact on the Stock Market

The stock market has been affect by speedily spreading credit crisis caused by the subprime defaults and now the problem is spreading to the other borrowers like a virus. There is a strong possibility that the stock market might crash, resulting the downfall of the US in the international market. Prices of goods produced in the US would rise, and they would have to rely heavily on exports, causing an enormous outflow of US currency.

Recently, the market had a bit of a rise thanks to the Feds decision to lower the discount rate for banks, flooded cash into the economy and attempted to bring things back