Understanding Sub-Prime Mortgage

Sub-Prime Mortgage is no more a unknown word. People have started discussing it over coffee and it has suddenly become a buzz word. In the past 2 weeks I have notices at least 5 headline articles having this keyword in newspapers. So, its natural that everyone is eager to know more about the crisis which brought about the downfall of a 150 year old company. Here, I try to explain this crisis in simple "human-readable" terms.

Before dwelling into this hot issue, let me describe the current state of affairs (majorly in U.S market). We have seen that Lehman Brothers have filed for bankruptcy under Chapter 11. AIG has been taken over in a multi-billion dollar deal, to keep it afloat for god knows how long. Merryl Lynch was taken over (the deal was more like a give away price). Goldman Sachs and Morgan Stanley are no more just investment banks. Freddi Mac was brought by the US govt. And looks like many more are going under the hammer. So why is this chaos in the market. Well, to explain this I will have to start with the happenings as back as in 2001.

The US real estate industry witnessed a boom between 2001 and 2005, with property prices soaring to historic highs due to low property loans, interest rates and other factors. Some of the weaker borrowers, who were either on the verge of defaulting on their financial commitments or had already done so, owned house properties whose values had risen dramatically on paper. So lenders looking at increasing their margins were quick to spot an opportunity and lent money to such borrowers on the basis of this increase in the paper value of their homes and these loans were either used to repay the old loans or for other expenses. All was fine till the housing party crashed.

The US property bubble collapsed, and interest rates began to rise. The rising rates led to a spate of defaults by borrowers, as a result of which several US sub-prime mortgage companies had to declare bankruptcy.

The result was that the shares of lenders dealing in sub-prime mortgages took a tumble. That's not all. The effect spread to the entire financial markets because these lenders had raised monies on the basis of such loans and were now not able to pay them back. And the ripple turned into a wave, affecting a wide section of the markets, and then spread overseas.

Exact definition of sub-prime mortgage:
A sub-prime mortgage is a loan offered by a lender to a borrower with a poor credit history (meaning he has defaulted on his financial commitments in the past) against the security of his house property. Such borrowers are called sub-prime borrowers. Since the risk of default is high, these loans are offered at relatively higher interest rates compared to loans offered to people with an impeccable repayment track record. However these sub-prime mortgage loans are relatively much cheaper than completely unsecured loans to the same profile of borrowers.

How does this affect Indian market and does this slow down the Indian Growth Wagon?
The US sub-prime crisis has had a short-term impact on the Indian stock market and on credit instruments with overseas investments. Collateral damage in India was extremely limited, as Indian entities do not own structured finance instruments. In effect, all it has managed to achieve is to create panic among investors. But soon those who were too quick to shed off their shares will repent their hasty decision. Our market is strong (or as strong as before the Wall Street crash), and it is highly unlikely that a sub-prime mortgage crisis will ever happen in India, since most of the Indian population which has bad credit rates are Non-prime users. Borrowers falling in this category may have never defaulted, but have low incomes or may not have proof of such incomes. These people may have borrowed earlier, but from local moneylenders and not banks or formal institutions. This is the case even with the ridiculously high interest rates the local money lenders charge. There is a reason for this. Since lower income group people do not find the need for large capital investments, they only need to borrow to sustain their daily needs. So they would prefer small amount, short duration, no surety loans, which no banks offer. Because of this, I think there is extremely less chance that the Indian markets will fall as it did in the US for this reason. But I do think that it is time the property bubble collapsed in India too.