A primer about the sub-prime crisis in the stock market

First, what is sub-prime?

When banks lend money to people, they broadly classify them into prime and sub-prime debtors, where the former are people who are considered creditworthy and the latter, less so.

Normally banks don't lend to those who are not creditworthy, do they?

While it will be prudent not to lend to anyone other than the creditworthy, banks do lend to sub-prime debtors. However, since these debtors are considered less creditworthy for reasons such as low income, banks usually lend to them at higher rates of interest.

Sub-prime borrowers pay a risk premium, may we say?

Yes. And in some cases, risks were high: loans were given to NINJA borrowers (that is, No Income, Job or Assets). This is the genesis of the 'sub-prime crisis' that is playing itself out currently on global markets.

How is sub-prime crisis defined?

Firstly, one must understand that though the word 'sub-prime crisis' is being used as a generic term, it actually refers to a credit problem among sub-prime borrowers (they account for 8 per cent of total mortgages in the US) in the residential market in the US. Like borrowers anywhere in the world, the interest paid on residential mortgages in the US is linked to the central bank's benchmark and in this case, the US Federal Reserve's Fed Funds Rates.

Can we trace back the problem to find out when things began to turn messy?

Between 2004 and 2006, because of incipient inflation in the US economy, the Federal Reserve or Fed increased its Fed Funds rate (the overnight rate at which banks lend to each other) from 1 per cent all that way to 5.25 per cent and the discount rate (the rate at which the Fed lends to banks) from 2 to 6.25 per cent. Because of this, holders of residential mortgages too saw their payments on their house loans rise. This rise in rates was a disaster in the making for the banks that gave loans to subprime borrowers. (However, the Fed, in an unusual move, decreased the discount rate by 50 basis points to 5.75 per cent on August 17 to increase liquidity in markets.)

Defaults would have increased when interest rates, and therefore the repayments, rose?

True, because the first issue with subprime borrowers is that they are likely to be low-income people. When faced with higher mortgage payments, they fell behind on their payments and in cases, some also became delinquent and banks started repossessing houses.

The banks would have sold the repossessed houses to recover the dues?

In the normal course, yes. However, because of higher interest rates, people became more cautious in borrowing to buy houses and there was a general slowdown in demand in the housing market, causing these banks to hold assets that people weren't just willing to buy.

Did no one see the crisis coming?

The so-called sub-prime crisis started unfolding when people started defaulting on their housing mortgages. Initially, it was thought that the problem was only limited to a few lenders and people didn't give it much thought. A testimonial to the fact that people didn't give it much thought is best highlighted when one looks at the level of the Dow Jones Industrial Index. The news of the sub-prime defaults was highlighted earlier in the year itself but the Dow actually closed at its highest level ever of 14,000 on July 19. Then things started unravelling.

The lenders take the hit when borrowers default, but we find the crisis spreading far and wide. How so?

That is because mortgages held by banks are typically bundled and sold to other institutions. These institutions will then slice these mortgages into residential mortgage backed securities (RMBS) or in other words, securities that are backed by collateral; the collateral here being the mortgages held by sub-prime borrowers.

And then?

These RMBS are then rated by rating institutions such as Moody's and Standard & Poor's based on various parameters...

Which is why the wrath has now turned on the rating agencies?

That's right. These RMBS are then divided further and sold as collateralised debt obligations or CDOs to various investors; and investors will buy these CDOs based on their appetite for debt.

Risky appetite?

Obviously. The people who hold the riskiest debt also get paid the highest when times are good, and get hit first when times are bad.

When did the issue surface?

The CDO issue first arose in June when a Bear Stearns hedge fund borrowed money from Merrill Lynch and gave their CDOs as collateral. Merrill Lynch decided to sell the collateral but soon realised that there was something wrong when they were unable to sell because their sale was driving down prices.

'Painful lesson in sub-prime', as the media reports?

And a costly one, too. Soon the market realised that there was a serious issue with the CDOs that went just beyond the Bear Stearns debacle. Essentially since these CDOs are part of RMBS, people realised that there was little or no solid collateral backing the RMBS because of the defaults by sub-prime borrowers.

An 'asset' that turned out to be hollow?

Exactly. And then two issues arose. One, no one knew how much of these CDOs banks and financial institutions were holding; and two, banks and financial institutions didn't know how much their CDOs were worth because the market for the CDOs had practically collapsed. Because of this, the markets started punishing the banks that held these CDOs and that is cause behind the volatility that one is currently seeing in global equity markets. It also emerged that there were more lenders caught in this sub-prime mess than was initially thought...

Do we know how many are affected by the problem on hand?

As of now, it has been estimated that 127 lenders have been caught in this. On August 15, the shares of Countrywide, the largest mortgage lender in the US, fell by 13 per cent after they issued warning about the potential hit on their balance sheet. One of the biggest concerns of this debacle is that instruments that were rated at AA have now started defaulting.

Have the rating agencies woken up?

Jolted from slumber, one may say. Rating agencies have now started to downgrade all RMBS backed by sub-prime mortgages and that will force banks to sell them because of capital norms and this will only cause a further plunge in prices.

Now, what are the lessons from the crisis?

This sub-prime mess raises two very important issues. One, the way banks lend money willy-nilly to people without properly checking their credentials; and two, the absolutely pathetic rating process used by the rating agencies. While both are hazardous to the system, the latter raises issues of moral hazard because the rating agencies profited massively from rating these RMBS.

Can we say that the worst is safely behind us?

Doubtful. It looks very likely that we are merely at the tip of the proverbial iceberg as far as the sub-prime crisis is concerned and that there is much more below the surface.