THE FINANCIAL JUNGLE

SUB PRIME CRISIS

by

Prof Anil Menon

It is said about the US subprime crisis that excessive liquidity brought it upon us, and now liquidity is
being poured to help the economy come out of the deep waters. So the cause of the disease is the
medicine for the disease. Welcome to the paradox of the subprime crisis. This crisis has been the most
talked about event in recent times. It has been equally foxing to many. The present article seeks to
logically analyse its causes and effects.

Q1) What is the subprime crisis?

Ans. The word “Sub prime” can be divided into two words, i.e.

“Sub” meaning below.

“Prime” meaning quality.

Sub prime, thus, refers to those borrowers who were not eligible of getting loans, but were
given the same by US banks. In case of such loans, the rate of interest is higher. It is this higher
margin which attracted many commercial banks in US to go in for sub prime lending. The
default by the borrowers set off a chain of events leading to the present crisis.

Q2) What is the origin of this crisis?

Ans. The soft interest policy adopted by Mr. Allan Greenspan the erstwhile Chairman of the US
Federal Reserve (the Central Bank of US responsible for monetary policy) initiated the crisis. In
fact he was famous for his “Greenspan Put” effect which referred to his tendency to drop
interest rates. Interest rates in the economy were reduced to as low as 1 per cent over a period
of time.

Q3) What was the strategy behind the Greenspan Put effect?
Ans. The strategy was to convert US from a savings economy to a consumption led economy.
With easy availability of credit, Americans borrowed and spent more. They started buying
various assets including houses. The ensuing boom in the real estate sector led to positive
effects on the overall economy. However this expansion of debt led to US economy getting
increasingly leveraged.

Q4) Why are the effects of the sub prime crisis serious & how did it spread to other
economies?

Ans. The crisis originated in the Unites States which accounts for about 25% of the world
wealth. Also it affected the banking sector which is the heart of an economy. The subsequent
credit crunch hurt all the other economic sectors. Further the loans given by US Banks were
sold to investors globally vide a process known as securitisation.

Q5) What is the securitisation process?

Ans. Once loans are given, funds are normally blocked till their maturity. However, through the
process of securitisation, these loans is converted into Mortgage Backed Securities (MBS) and
sold to investors. This helped US banks get immediate liquidity apart from a good spread on
the loans originated by them. For e.g. If the interest rate on the loans was 5%, the US banks
would retain say 0.25% and pass on the balance 4.75% to the investors. The investors would
pay upfront to the US Banks the value of the loan advanced.

Q6) What is a MBS and why did investors globally invest in MBS?

Ans. MBS essentially are derivatives. A derivative is an instrument which has no original value
of its own; and derives its value lies from an underlying asset. In this case MBS derived their
value from the underlying real estate loans. The MBS were securitised on two ways: with and
without recourse.

Q7) What is with and without recourse type of securitisation?

Ans. With Recourse Securitisation: This means in case of default by the borrower, the
investor could always go back to the bank which originally gave the loan (the originator bank).
The risk of the bad loan therefore lies with the originator bank.
Without Recourse Securitisation: It is the reverse of the above. Here the investor will have to
bear the risk of default and cannot turn back to the originator bank. This technically meant that
risk of default by the borrower was transferred to the investors from the originator bank.

Many global investors invested on a without recourse basis. This was because the returns paid
to the investor were higher. (Obviously due to the higher risk involved).

Also these MBS in general had a good rating.

Q8) How did these securities enjoy a good rating?

Ans. This is where the credit rating agencies resorted to a kind of ‘financial engineering’ and
played a dubious role. They designed Collateralized Debt Obligations (CDO), which was
essentially a package of prime and subprime loans. They worked backwards and adjusted the
proportion of various loans such that on an overall basis the CDO enjoyed a good rating.

Q9) What is a Home Equity loan?

Ans. Due to the increased demand for real estate assets, its prices started rising. Banks further
gave top up loans against the same asset. Such loans are called Home Equity Loans. In short
Americans started using their Homes as ATMs and treating Debt as a part of income. This
vicious cycle led to an asset bubble. Note: An Asset Bubble is created when the prices of assets
go up irrationally. The bursting of bubble leads to disastrous economic consequences.

Q10) What led to the precipitation of this crisis?

Ans. It was primarily to prevent an asset bubble burst that Ben Bernanke the current Chairman
of the Federal Reserve reversed the lower interest rate policy and started increasing interest
rates. However this led to a series of unprecedented defaults. Thanks to securitisation, the crisis
which originated in the US quickly spread to other global economies. In fact no economy was
spared.

Factoid:

i) As per a report by the National Bureau of Economic Research, the United States
economy slipped into recession due to the subprime crisis which lasted 18 months.
ii) 230 banks have collapsed due to the subprime crisis.
 iii) Lehman Brothers a 160 year old global investment Bank and Bear Sterns were some of
the high profile bankruptcies.

iv) The US Govt. had to resort to bailouts of many firms using tax payers’ money. Total bailout
package in pledges has touched an unprecedented $9.7 trillion. This amount would be
enough to send a $1,430 check to every man, woman and child alive in the world.

v) The bailout packages have considerably weakened the budgetary position of the Federal
Government especially during the last two years. The budget deficit now averages 9-1/2 percent
of national income during that time. For comparison, the deficit averaged 2 percent of national
income for the fiscal years 2005 to 2007, prior to the onset of the recession and financial crisis.
vi) The recent deterioration was largely the result of a sharp decline in tax revenues
brought about by the recession and the subsequent slow recovery, as well as by increases in
federal spending needed to alleviate the recession and stabilize the financial system. As a result
of these deficits, the accumulated federal debt measured relative to national income has
increased to a level not seen since the aftermath of World War II.
vii) The Outstanding Public Debt as of 16 Oct 2010 is:

viii) The estimated population of the United States is 309,304,190

so each citizen's share of this debt is $44,015.17.
ix) The National Debt has continued to increase an average of
$4.14 billion per day since September 28, 2007!
x) The effect of the subprime crisis is still lingering. Even as of Sept 2010 the
unemployment rate in US is very high at 9.6%

Prof Anil Menon (anilrmenon1@simplifiedfinance.net) interacts with the participants of the

Family Managed Business Program at the S.P. Jain Institute Of Management & Research in the
area of Finance.