ct all begins with an American wanting to live the famed American dream.

So he seeks a housing loan to give shape to his dream home. But there is a slight problem. He
doesn't have good credit rating. This means that he is unable to clear all the stringent
conditions that a bank imposes on an individual before it sanctions a loan.

Since his credit is not good enough, no bank will give him a home loan as there is a fear that
the chances of a default by him are high. Banks don't like customers who default on their
payments.

But lo!, before the American dream can fade away, there enters a second American -- usually
a robust financial institution -- who has good credit rating and is willing to take on some
amount of risk.

iven his good credit rating, the bank is willing to give the second American a loan. The
bank gives the loan at a certain rate of interest.

The second American then divides this loan into a lot of small portions and gives them out as
home loans to lots of other Americans -- like the first American -- who do not have a great
credit rating and to whom the bank would not have given a home loan in the first place.

The second American gives out these loans at a rate of interest that is much higher rate than
the rate at which he borrowed money from the bank. This higher rate is referred to as the sub-
prime rate and this home loan market is referred to as the sub-prime home loan market.

lso by giving out a home loan to lots of individuals, the second American is trying to hedge
his bets. He feels that even if a few of his borrowers default, his overall position would not be
affected much, and he will end up making a neat profit.

Now if this home loan market is sub-prime, what is prime? The prime home loan market
refers to individuals who have good credit ratings and to whom the banks lend directly.

Now let's get back to the sub-prime market. The institution giving out loans in the sub-prime
market does not stop here. It does not wait for the principal and the interest on the sub-prime
home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has
given it the loan.

o what does the institution do?

It goes ahead and ¦securitises' these loans. Securitisation means converting these home
loans into financial securities, which promise to pay a certain rate of interest. These financial
securities are then sold to big institutional investors.

Many investment banks (or institutions like the ¦second American' in our story) sold
complicated securities that were backed by debt which was very risky.

And how are these investors repaid? The interest and the principal that is repaid by the sub-
prime borrowers through equated monthly installments (EMIs) is passed onto these
institutional investors.
Ohe institution giving out the sub-prime loans takes the money that it gets by selling the
financial securities and passes it on to the bank he had taken the loan from, thereby repaying
the loan. And everybody lives happily ever after. Or so it would have seemed.

The sub-prime home loans were given out as floating rate home loans. A floating rate home
loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate
home loans also go up. As interest rates to be paid on floating rate home loans go up, the
EMIs that need to be paid to service these loans go up as well.

ith US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers
hard. A lot of them in the first place had unstable incomes and poor credit rating.

They, thus, defaulted. Once more and more sub-prime borrowers started defaulting, payments
to the institutional investors who had bought the financial securities stopped, leading to huge
losses.

The problem primarily began with the United States keeping its interest rates very low for a
very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower
interest rates led to buyers wanting to take on bigger loans, and thus bigger and better homes.

ut life was fine. With the American economy doing well at that time and housing prices
soaring on the back of huge demand for real estate and bigger and better homes, financial
institutions saw a mouthwatering opportunity in the mortgage market.

In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures
before extending housing loans to people with unstable jobs and weak credit standing.

Few controls were put in place to handle the situation in case the housing ¦bubble' burst.
And when the US economy began to slow down, the house of cards began to fall.

The crisis began with the bursting of the United States housing bubble.

slowing US economy, high interest rates, unrealistic real estate prices, high inflation and
rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of
consumer spending, a virtual halt to new jobs, and foreclosures and defaults.

Sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A
deluge of such defaults inundated these institutions and banks, wiping out their net worth.
Their mortgage-backed securities were almost worthless as real estate prices crashed.

The moment it was found out that these institutions had failed to manage the risk, panic
spread. Investors realised that they could hardly put any value on the securities that these
institutions were selling. This caused many a Wall Street pillar to crumble.

s defaults kept rising, these institutions could not service their loans that they had taken
from banks. So they turned to other financial firms to help them out, but after a while these
firms too stopped extending credit realizing that the collateral backing this credit would soon
lose value in the falling real estate market.
Now burdened with tons of debt and no money to pay it back, the back of these financial
entities broke, leading to the current meltdown.

Ohe problem worsened because institutions giving out sub-prime home loans could easily
securitise it. Once an institution securitises a loan, it does not remain on the books of the
institution.

Hence that institution does not take the risk of the loan going bad. The risk is passed onto the
investors who buy the financial securities issued for securitising the home loan.

Another advantage of securitisation, which has now become a disadvantage, is that money
keeps coming in.

Once an institution securitises the first lot of home loans and repays the bank it has borrowed
from, it can borrow again to give out loans. The bank having been repaid and made its money
does not have any inhibitions in lending out money again.

iven the fact that institutions giving out the loan did not take the risk, their incentive was in
just giving out the loan. Whether the individual taking the home loan had the capacity to
repay the loan or not, wasn't their problem.

Thus proper due diligence to give out the home loan was not done and loans were extended to
individuals who are more likely to default.

Other than this, greater the amount of loan that the institution gave out, greater was the
amount it could securitise and, hence, greater the amount of money it could earn.

After borrowers started defaulting, it came to light that institutions giving out loans in the
sub-prime market had been inflating the incomes of borrowers, so that they could give out
greater amount of home loans.

By giving out greater amounts of home loan, they were able to securitise more, issue more
financial securities and earn more money. Quite a vicious cycle, eh?

nd so the story continued, till the day borrowers stop repaying. Investors who bought the
financial securities could be serviced.

Well, that still does not explain, why stock markets in India, fell? Here's why. . .

Institutional investors who had invested in securitised paper from the sub-prime home loan
market in the US, saw their investments turning into losses. Most big investors have a certain
fixed proportion of their total investments invested in various parts of the world. So...

nce investments in the US turned bad, more money had to be invested in the US, to
maintain that fixed proportion.

In order to invest more money in the US, money had to come in from somewhere. To make
up their losses in the sub-prime market in the United States, they went out to sell their
investments in emerging markets like India where their investments have been doing well.
So these big institutional investors, to make good of their losses in the sub-prime market,
began to sell their investments in India and other markets around the world. Since the amount
of selling in the market is much higher than the amount of buying, the Sensex began to
tumble.

The flight of capital from the Indian markets also led to a fall in the value of the rupee against
the US dollar.



  
  

Of course! Sub-prime crisis alone could not have caused such mayhem, although it is to
blame for the beginning of the end.

This     
 from sub-prime to prime mortgages, home equity loans, to
commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans),
to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds,
to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk
are indeterminate, etc.

It has been a total systemic failure that has its roots in the US real estate and the sub-prime
loan market.