When a customer avails a loan from a bank, the bank may or may not give the customer the loan on the basis of whether they think he/she can repay the loan or not. This is done by evaluating the credit-rating of the customer, which depends on his/her salary, other loans, credit history etc. A higher credit rating signifies a better probability the payment of the loan and hence people are classified into prime (higher credit rating) and sub-prime (relatively lower credit rating) customers respectively.
As the credit rating of the person decreases, the rate of interest at which he/she has to repay the loan increases as the risk borne by the bank is more. However, if the credit rating is lesser than a particular range, banks do not sanction the loan as the risk is too great to take by the banks.Credit Rating Agencies carry out the task of rating customers. For example, in India it is done by the Credit Rating Agency of India (CRAI).
In the scenario in which the Sub-Prime Crisis took place, real estate in America was booming. The fed rate (the rate at which the federal bank gives money to banks) was low. This was primarily due to the laissez-faire approach followed by the government. As a result, the rate at which the banks were offering loans to the customers was also low.
The American culture involves a number of immigrants coming to America in order to realize the “American Dream”. No matter what place in the world, living in one’s own house is a symbol of wealth and economic improvement. These conditions provided the lower middle class a perfect and safe opportunity to acquire loans to buy homes. The general psychology prevailing in the masses was that even if they couldn’t pay the loan they had taken they could come up with alternative solutions like -:
1) Sell the house at a greater price because by then the price of the house would have gone up),repay the loan and walk away with a clean profit.
2) Use the new present increased value of the house as leverage for an extension on the loan.
3) Use the new present increased value of the house for a loan fro another bank to pay back the original loan.
Hence, a lot of Americans started availing loans, which included a lot of sub-prime customers. The banks acted on the notion that with the soaring real estate prices, even if anything goes wrong, they could keep the house as collateral and hence make a tidy profit as the value of the house would increase with time. So, they started sanctioning loans to a number of sub-prime customers. The credit rating agencies also have been accused of not rating customers correctly.
Meanwhile, as the customers were too many, the banks did not have enough funds to provide for these loans. Hence the idea of Mortgage Based securities was floated.Loosely put, financial institutions started offering securities to people in the market on the basis of getting returns on the customers paying back the loans. The people investing in these markets include people of all sections of society. Hence, the country as a whole got exposed to financing the sub prime loans.
With the financing of these loans, as demand for real estate started exponentially increasing, so did the real estate value. This had a number of indirect consequences.
As people bought houses, they started buying commodities for their homes. A new home also meant a rise in social status. Hence, by psychology, they started spending more too(especially as they thought their net worth was anyway increasing with the soaring real estate prices).This spiked up the inflation rate in the country.
As the inflation rate shot up, the government increased the fed rate in order to reduce the banks from giving loans and in turn reduce spending. But this resulted in the people seeking extension for on their loans started being offered an interest rate much higher than before. The burden of this rate being too much to bear, the customers started defaulting on the loans. As the new interest rates were more, the number of new loans financed also reduced, which meant less demand for real estate. In any case, the real estate market was booming for many years and the prices where much higher than the actual value reflected by the growth rate of the country. Hence, the prices of real estate started spiralling. This started widespread panic.
The number of people defaulting on loans mushroomed. The real estate prices fell. When banks took custody of the houses that were bought, the value of the real estate was low. In fact, in many cases it was much lower than the value at which the loan was financed, which meant huge losses for the banks. As the banks started losing money, the value of the Mortgage Based Securities catapulted. Hence the investors also started losing money. As banks lost huge amounts of money, to make up for it and straighten their balance sheets, they had to cut back on costs which resulted in a lot of employees getting fired. This topped with the growing depression in the people due to loss of their home’s started having an impact on growth.
With the losses in jobs and people losing their homes, spending reduced. This caused the growth to reduce and this is the stage at which the economy is today.
Current events regarding the crises:
- Lehman Brothers, one of the largest global banks went bankrupt.
- Two huge financing institutions Fannie Mae and Freddie Mac went bankrupt.
- Citibank, one the premier global banks posted huge losses which led to the resignation of their chairman. Currently, Vikram Pandit, an Indian is leading the bank.
- The US government announced a 700 billion dollar bailout plan to deal with the crises.