Right, starting with the term ‘sub-prime mortgage’. Mortgage refers to loans given to borrowers. Every bank has certain Prime customers. These are the customers to whom the bank ‘wants’ to give home loans to. The reason for this is the high credit ratings these customers have (Credit rating refers to how the banks perceive the ability of the borrower to return the loans with interest. A customer with high credit rating is someone who is deemed to be likely to return the money, based on his record of past borrowings, as well as public image and various other factors). Hence, it is preferable for the banks to loan these people the money. They also give them lower interest rates compared to other customers.
Now, recently, the banks had a lot of money in terms of liquid assets (non-fixed assets, usable cash) available to them. A combination of low interest rates (which reduced defaults) and large capital inflows from outside the U.S. (booming trade) created a surplus of ‘loanable’ liquid assets with the banks. So, now they wanted to loan this money as well. The problem was, that the prime customers were very few in number, and given the large number of banks, no bank was able to loan its entire cash to prime customers.
Hence, the investment banks had to shift to non-prime customers, technically called as sub-prime customers. These are people with less than desirable credit ratings. But still, the banks had to give out loans. For that, they started attracting these people with better interest rates (better implies lower rates), as well as relatively very easy payback options (Initially, I thought why the banks couldn’t sit tight with their money instead of taking high risks. But then, I realized that even if one investment bank comes out with such offers, the other banks are practically forced to do the same, otherwise they will be ripped off all their business to the other bank with supposedly better offers).
Also, in those years, the housing prices in the U.S. shot upwards. So, the people started to consider real estate as a viable investment option. They would buy the houses with loans and then expect the prices to shoot up. The plan was, when the price was sky-high, they would sell the property, pay off the debt and walk away with a handy sum of profit. The other option was refinancing in a few years time (Refinance implies, when the property for which I have taken a loan has increased in value, I would approach my lender to simplify my loan conditions, make the payment options easier for me, since my property has increased in value).
Herein lies the problem. As the number of customers getting home loans and investing into new, unoccupied homes shot upwards, it resulted into a surplus of available houses. By conventional rules of demand and supply, this led to a reduction in the demand, and hence a dip in the housing prices. The real estate prices stopped rising, and instead started declining.
Now consider a scenario, I bought a house for $120,000, initially paying all the installments diligently on time. After some time the prices started to fall. Now, 12 months down the line, I realize that my loan amount pending is $100,000 and the current value of my house is $75,000. So now I have an incentive to simply walk away from the home. Let the lenders possess the home and do whatever they want with it. At least I will save some of my investments. This is especially a possible situation given that the housing prices fell drastically and the loans were given to sub-prime customers who already have low credit rating. Hence, the number of defaults on loans increased, the banks did not even get their principal of the lent sums back, leave alone the interest. This caused a major problem with the banks with regard to available cash and liquidity.
It was this lack of available cash that caused the major chunk of problems with the U.S. financing system, causing problems with larger-than-life banks like Merrill-Lynch, AIG etc. (The bigger the bank, the more the amount loaned, the more the default, the more will be the amount lost, hence the biggest banks were strongly affected)
Now, recently, the banks had a lot of money in terms of liquid assets (non-fixed assets, usable cash) available to them. A combination of low interest rates (which reduced defaults) and large capital inflows from outside the U.S. (booming trade) created a surplus of ‘loanable’ liquid assets with the banks. So, now they wanted to loan this money as well. The problem was, that the prime customers were very few in number, and given the large number of banks, no bank was able to loan its entire cash to prime customers.
Hence, the investment banks had to shift to non-prime customers, technically called as sub-prime customers. These are people with less than desirable credit ratings. But still, the banks had to give out loans. For that, they started attracting these people with better interest rates (better implies lower rates), as well as relatively very easy payback options (Initially, I thought why the banks couldn’t sit tight with their money instead of taking high risks. But then, I realized that even if one investment bank comes out with such offers, the other banks are practically forced to do the same, otherwise they will be ripped off all their business to the other bank with supposedly better offers).
Also, in those years, the housing prices in the U.S. shot upwards. So, the people started to consider real estate as a viable investment option. They would buy the houses with loans and then expect the prices to shoot up. The plan was, when the price was sky-high, they would sell the property, pay off the debt and walk away with a handy sum of profit. The other option was refinancing in a few years time (Refinance implies, when the property for which I have taken a loan has increased in value, I would approach my lender to simplify my loan conditions, make the payment options easier for me, since my property has increased in value).
Herein lies the problem. As the number of customers getting home loans and investing into new, unoccupied homes shot upwards, it resulted into a surplus of available houses. By conventional rules of demand and supply, this led to a reduction in the demand, and hence a dip in the housing prices. The real estate prices stopped rising, and instead started declining.
Now consider a scenario, I bought a house for $120,000, initially paying all the installments diligently on time. After some time the prices started to fall. Now, 12 months down the line, I realize that my loan amount pending is $100,000 and the current value of my house is $75,000. So now I have an incentive to simply walk away from the home. Let the lenders possess the home and do whatever they want with it. At least I will save some of my investments. This is especially a possible situation given that the housing prices fell drastically and the loans were given to sub-prime customers who already have low credit rating. Hence, the number of defaults on loans increased, the banks did not even get their principal of the lent sums back, leave alone the interest. This caused a major problem with the banks with regard to available cash and liquidity.
It was this lack of available cash that caused the major chunk of problems with the U.S. financing system, causing problems with larger-than-life banks like Merrill-Lynch, AIG etc. (The bigger the bank, the more the amount loaned, the more the default, the more will be the amount lost, hence the biggest banks were strongly affected)
