2008 Sub-Prime Loan Crisis Explained!!!

Did you ever realize why during a recession in the economy, newspaper articles are brimming with references to the 2008 subprime crisis? Did you ever feel helpless that due to your lack of knowledge you could not comprehend the articles to their fullest? Well, you’ve got to be absolutely relaxed as today I have attempted to explain the story on 2008 subprime crisis and now those of you who always wanted to understand, read carefully.

Okay, so without further ado, we get going!

‘Subprime’ literally means a below average credit classification of borrowers with a tarnished or limited credit history. So, are these borrowers the culprits? Wait for a while and then decide for yourself. Housing loans were available to anyone which led to an increase in real estate prices from 1996 to 2006 as housing prices skyrocketed 194%. Subprime lending increased by 30 billion a year to over 600 billion in 10 years. Therefore, this activity of subprime lending was going on from a long time but the bubble finally burst in 2008.

Here,securitization was a weapon of mass destruction and if it were a weapon of mass destruction, then it is safe to say that banks, investment banks and credit rating agencies were the manufacturers of those weapons. Alien terminologies? No worries, lets break it down in a simple manner.

The Structure which led to the crisis

Role of Banks

Banks used to lend to subprime borrowers, in essence those borrowers who, in a normal world and with sane bankers would never get access to credit simply because of their low earnings, past defaults, lack of security and a lack of higher earning ability. It’s akin to lending to a beggar. No, that’s not an exaggeration, trust me. And imagine the havoc it must have caused when such loans were advanced to a plethora of such beggars. Loan to value ratios were above 1 in most of the cases, which means that if the value of the house is Rs. 100, the loan advanced by the bank would be more than Rs. 100. I mean why in the world would a bank lend more than the value of the house? Feeling sorry for the banks because of the losses they must’ve incurred? They are not worth the empathy. Here comes the role of investment bankers and credit rating agencies who protected the banks and in the process earned a hefty sum themselves. Over to you, investment banks.

Role of Investment Banks

Investment banks helped in the securitization process.

What is Securitization?

In a securitization process, loans which are advanced by banks to the borrowers are pooled together and sold to an investor. Suppose, a bank has lent Rs 100, 200 and 300 to borrowers A,B and C respectively. So, these loans worth Rs.600 are pooled together and sold to an investor. So whatever repayments A, B and C will make in the future, that money will flow to the investors because in effect they have purchased the loan portfolio of the banks. The investors get something known as bonds indicating that they are now the holders of the loan portfolio. And who are these investors? A variety, ranging from pension funds, sovereign funds to normal retail investors like you and me. Investment banks get a fee for arranging this transaction and the fees is hefty, usually as a percent of the transaction value. Okay, so clear so far? Now, anyone would have a question, what’s the credibility of such bonds? Pension funds, for eg, are investing huge sums of people’s hard earned money so naturally credibility is something they are looking for. Well, that’s right. Here, comes the role of credit rating agencies. Over to you, credit rating agencies.

Role of Credit Rating Agencies

Credit Rating Agencies are entrusted with the responsibility of issuing a credit rating to such bonds mentioned above so that prospective investors would have credibility before investing. Ideally, they study a host of factors which would affect the credit rating of these bonds. For eg, the source of cash inflows of the loan portfolio, the average age of the borrowers, their future earnings potential, etc. After studying all these factors in depth, if the rating agency feels that there is a lot of potential in the borrowers and they would service the loans on time, the agency issues a good credit rating, typically AAA or above, indicating investment grade credit rating, meaning it is safe for the investors to invest in these bonds. Investors take cue from these ratings and make their decisions accordingly. Alas! Only if the credit rating agencies were so diligent and honest. The major problem with such a setting is that credit ratings are 'issuer paid ratings', meaning the entity that issues the bonds, bank, in this case, pays the fees to the credit rating agency for their services and this makes them pliable to issue a favorable rating to the banks’ bonds. If not, the banks will go to another credit rating agency and the former credit rating agency will lose business. Well, it’s nothing but a form of bribery. Sad, isn’t it? Well that’s the harsh reality.

Summary of the transaction

 Banks get rid of the toxic loans from their books and get their money.

 Investment banks get their fees for arranging the securitization transaction.

 Credit rating agencies get their fees for issuing a favorable rating.

 Investors get their......Yes, you guessed it right. Investors lose their money.

The aftermath

Like this a lot of vulnerable investors lost money in the 2008 subprime crisis and to cover their losses, withdrew their money from markets abroad which led to a huge crash in the markets and investing & trading activities had come to a standstill, there were huge job losses, confidence in the economy across the world was at its lowest ebb and a recession soon followed. If you didn’t know, now you finally know. This article was enough to let a layman understand the main reason behind the 2008 subprime crisis. However, to disseminate more knowledge about the same topic, I will be coming with part II in due course. Until then, rejoice for you have finally known something you've always wanted to know.