The understanding that ‘high risk investments generate high returns’ attracted a lot of lenders intending to make quick profits, to offer very risky Sub-prime mortgage loans (or housing loans or junk loans) to people with unstable incomes or low creditworthiness. Not eligible to meet the strict standards and conditions stipulated by prominent banks and financial institutions for availing a loan, these borrowers with bad credit history and high chances of default payments, approached subprime lenders daring the higher rates of interest, to try their luck at the booming real estate market.

Subprime Lenders – The Secondary Financial Institutions

Subprime lenders were secondary financial institutions that had good credit rating, to which the prominent banks and financial institutions were ready to extend loans, as they maintained track records of prompt repayments. These secondary institutions, ready to take some amount of risk for better returns, borrowed huge sums of money from reputed banks at prime rate, split them into many small loans and offered them at a much higher rate of interest called subprime rate, to those deprived of loans by the prime banks. The higher rate of interest provided a safe hedge, in case of default by a few borrowers. This home loan market was referred to as the sub-prime home loan market.

Repayment of Prime Loans by the Secondary Financial Institutions

The secondary financial institutions disbursing loans in the subprime market did not wait for the principal and the interest on the sub-prime home loans to be repaid, to in turn repay their loans to the bank (the prime lender), which gave them the loans. Instead, through the process of securitization, they converted these home loans into financial securities that promised to pay a certain rate of interest and sold them to big institutional investors.

Though these financial securities backed by home loans with less credit rating were very risky, they became popular due to slightly higher interest that they paid, the source being the interest and the principal repaid through equated monthly installments by the home loan borrowers.

The secondary financial institutions giving out the sub-prime loans used the money they generated through the sale of financial securities, to repay the prime loan. Having repaid the loans so early, these institutions were able to get fresh loans bigger than the earlier ones.

Rising interest rates and the repayment defaults by subprime home loan borrowers

Everything went on fine until the interest rates started increasing. When the interest rates were very low for a very long time, every aspiring realtor in the United States felt it wise to go for bigger loans and better homes. But, between 2004 and 2006, interest rates in US increased from one percent to 5.35 percent.

The sub-prime home loans which were given out as floating rate home loans, had their interest rates reset periodically, according to the increased benchmark interest rates, successively increasing the EMIs to be paid by the subprime borrowers to service these home loans. Higher EMIs made repayment of money difficult for the subprime borrowers who had unstable incomes and poor credit rating. As they defaulted, the promised interest from the financial securities purchased by the institutional investors stopped and huge losses were incurred.

Other factors that led to the collapse and impact on the stock market

Lured by business opportunities, institutions that extended heavy loans by relaxing the rules and regulations while evaluating the borrowers started losing control of the situation as the housing bubble burst. Slowdown in the US economy, increasing interest rates, misleading real estate prices, higher rates of inflation, peak oil prices, stagnated industrial growth, job losses, double digit unemployment rates, restricted consumer spending, freezing of new jobs, foreclosures and defaults together plunged the stock markets down.

Rising EMI’s resulted in huge defaults by sub-prime homeowners, eroding the net worth of the institutions and banks that offered subprime home loans. Crashing real estate prices diminished the value of mortgage-backed securities. Bad sentiments hit the market, as alarmed investors realized that the securities sold by these secondary financial institutions had less or no value, after they failed to manage the risk.

Increasing defaults by home loan borrowers forced these secondary financial institutions to search for other financial firms to service their loans. But, as the collateral backing was losing value due to dropping real estate prices, no firms risked extending support. With no means to survive, these institutions collapsed in no time and the markets registered the worst ever downtrend.

More reasons for losses

Ease of securitization of sub-prime home loans helped the secondary financial institutions to pass on the risk of default from its own books, to the books of institutional investors buying the financial securities. Also, repayment of prime loans with the money generated by selling the financial securities made further borrowing from prime lenders easier, resulting in fresh subprime loans. The prime bank having been repaid and made its money did not have any inhibitions in lending out money again.

Having effectively transferred the risk of default to institutional investors through securitization, the secondary financial institutions issuing loans did not care if the home loan borrower had the capacity to repay. Compromising on proper due diligence, these financial institutions aimed at maximizing the volume of loans. Incomes of borrowers were inflated to project them eligible for more loans. Thus more loans meant more securitization, which in turn meant more money, creating a continuous cycle of events.

End of the game

The process continued till the day borrowers stop repaying. Investments made by the US Institutional investors in securitized paper from the sub-prime home loan market turned into losses. Big investors who had a certain fixed proportion of their total investments invested in various parts of the world had to pull out their money, to maintain that fixed proportion and make good of their losses in the US subprime market. Stock markets around the world saw heavy selling than buying, bourses fell, losses mounted.

Is the crisis over yet?

This true impact of the crisis is yet to be ascertained as it is spreading from sub-prime to prime mortgages, home equity loans, to real estate loans, to unsecured consumer credit, to leveraged loans, to municipal bonds, to industrial and commercial loans, to corporate bonds and debentures, to the derivative markets etc.

The failure of this US real estate and the sub-prime loan market led to the failure of many systems that were directly or indirectly related to it, resulting in a worldwide financial crisis.