Sub-prime crisis 2008

What is the issue?

Ten years have been passed since the sub-prime crisis brought the global economy to the brink.

What is a sub-prime loan?

Generally, poor credit rating people are disqualified to apply for conventional mortgage or loan application.
They’re disqualified because they have higher risks that they are not able to make the loan payment due to their poor credit history.
Hence, Banks in US came out with a special type of loan to cater to these people in the form of “Subprime Mortgage” or “Subprime Loan”.
It refers to a loan given to a borrower who does not qualify for a regular home loan because of a poor credit record, low income and lack of job security.

What were its objective?

Banks did this on the expectation that the value of the underlying security or the property will go up in future.
So, they increased the mortgage interest rate, higher than the conventional loan,so that they could earn more with it.
On their part, Borrowers can rent out their house with higher value or they can sell the house with higher value.
Paying back the loan payment is not a problem at all for them, since the housing prices were booming at that time.
The borrowers also got their loans refinanced with the improvements in their credit ratings.
Even if they discontinued repayment, Banks could sell the property for a higher consideration due to appreciation in property prices.
The banks also repackaged all mortgages into an investment product and sell it to financial institutions all over the world to further reduce the risks and to get more loans.
This made global financial investors around the world to get involved in the subprime mortgage.
With housing demand exceeding supply, the cycle became beneficial for all the three stakeholders from 2005 to 2007 (Banks, borrowers and financial institutions).

What triggered the crisis?

The success was followed by an excess supply and ballooning prices of the underlying properties in the subsequent years.
The real estate market begins to cool down and the house prices begin to fall.
This made the subprime borrowers unable to pay their existing debt and they stuck up paying a much larger mortgage payment.
This causes many of these borrowers unable to make their house payment.
Also, financial institutions no longer want to invest and didn’t trust the bank anymore.
As a result, the banks further increased the mortgage interest rate so that borrowers who afford to pay can pay more.
But the conditions got worse with more and more borrowers failed to pay their monthly loan payment due to the interest rate increases.
A credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds while payment defaults triggered massive declines in banks and real estate incomes.
In 2008, Lehman Brothers declared bankruptcy.

What were the impacts on Indian economy?

With lower dependence on exports and a sizeable contribution of its GDP came from domestic sources, India faced a less severe impact.
Indian banks had limited exposure to the U.S. mortgage market as also to the financially-stressed global financial institutions.
Still, India’s fiscal deficit touched 6% of the GDP in 2008-09, from being just 2.7% in the previous year.

The fiscal stimulus provided under the backdrop of the crisis was never withdrawn after that, leading to the rise in twin deficits (FD and CAD).
India faced at least three major crisis-like situations since -

Also, Financial Stability and Development Council (FSDC) set up to settle disputes among regulators are also in need of an independent research team drawing from global experiences.
That would provide for an inter-regulatory coordination and macro-prudential supervision of the economy so that a sub-prime like crisis in the country could be avoided in the future.

Source: The Indian Express, The Hindu