Subprime Crisis: the Global Slowdown
The US and other major economies of the west are experiencing the slowdown in thisFY08, consequent to the subprime crisis. Sub-prime crisis whose origin is from thefinancial crisis in the United States (US) housing market. Subprime crisis refers to creditdefault by the sub-prime borrowers and consequent sharp rise in the foreclosures by theinvestors in the housing market.The word µsubprime¶ refers to borrowers (who are not rated as µprime¶). The prime borrowers are those who fulfill the criteria, viz: (i) credit scoring (ii) debt service toincome ratio (DTI) (iii) loan to value ratio (LTV). Subprime borrowers are a borrower,who fails to meet the prime criteria (mentioned above) and who do not have sound track record of repayment of loans.Housing market constitutes mainly of prime mortgages, subprime mortgages, Alt-Amortgages and home equity loans. Of these later three constitutes 50 percent of the totalmortgage loans.
The first sign of a crisis emerged in March 2007, when the shares of New CenturyFinancial Corporation, one of the largest subprime lenders in US were suspended amidfears that the firm could be heading for bankruptcy. In this FY08 many subprime lendersfacing credit crisis were bought and being regulated by Federal Reserve (Central Bank of US). In Q3 of the FY08 Lehman Brothers made an outstanding loss of $4 billion andwent bankrupt. Another financial institution AIG (American International Group) wasrescued by Federal Reserve by providing fresh loan of $85 billions.The floating interest rate on residential mortgage market in US market is linked to benchmark Federal Fund Rate (FFR), FFR is the overnight inter-bank rate. The interestrate on home mortgage was low, which not only made it affordable but also enabledinvestors to borrow at low cost and invest in these high yielding obligations (CDOs). Butlending institution charged interest rates on subprime mortgage at a higher rate thanconventional mortgage in order to compensate them from carrying higher risk.Albeit high rates of interest a special treatment was provided with unusualfinancial arrangements like little documentation or mere self-certification of income, noor little down payments, extended repayment periods and structured payment schedulesinvolving low interest rates in the initial phases which were µadjustable¶ and movedupwards sharply when they were µreset¶ to reflect premia on market interest rates. Mostof the adjustable rates of mortgages (ARMs) were hybrid products which combinesfloating rate and fixed rates. Hybrid, for instance, 2/28 hybrid meant initial 2 years with below market fixed rate and next 28 years with reset shocks.The growth in the US economy has been sustained by the booming housingmarket triggered by Dotcom bust in 2000. To control the incipient inflation in the USeconomy, as a monetary measure, Federal Reserve increased FFR and Discount rate(Discount rate is the rate at which the Federal Reserve provides liquidity support to banksand other financial institutions) to 5.25 percent and 6.25 percent respectively, 17 times of 25 basis point each during June 2004 and June 2006. Then prevailing FFR and discountrate was as low as 1 percent and 2 percent in previous years.