Report on subprime loan crisis

Subprime loan, or subprime mortgage loan, crisis came to the notice on 9^th august, 2007. Subprime loans are given to people with unstable incomes or low creditworthiness. It is, as it sounds, very risky. The only reason for giving subprime loans to such people is high profit that the investor gets some time period later. Here’s the detailed explanation.

An American has either good or bad credit rating, which is the decisive factor for banks to give loan to that American. Consider an American with bad credit rating. He needs loan to invest in the property. Since his credit rating is not good, he does not qualify for the loan. There is another American, or say, a financial institution, who has a good credit rating, hence qualifying for the loan. Second American, who has a good credit rating, goes to the bank and gets the loan. Now, to earn a good amount, he gives the loan to the first American, whose credit rating is not good. The rate of interest at which the second American gives loan to the first American is higher as compared to that of the bank. And this is his main income that he expects he will get in the near future.

The higher rate at which the second American has given loan to the first American is subprime rate.

The loan that the second American has given to the first American is subprime loan.

The above situation is subprime home loan market. Prime home loan market is a situation in which banks directly lend to individuals who have good credit rating.

What happens later is, the financial institution securitises home loans. Securitisation is the process of converting home loans into financial securities which promise to pay a certain rate of interest. Financial securities are then sold to big financial institutions, who then sell the financial securities and passes the money to the lender bank.

What went wrong if everything was going perfect? Here is the answer.

The problem began with the United States keeping its interest rates very low for a long time, hence making it easy for every American to go and get the loan. These rates are regulated by the Federal Reserve System-the central banking system of the United States.

Next, subprime loans were given at floating rate, i.e., rate which is not fixed. These rates increased, equated monthly instalments (EMI for short) increased and ultimately, subprime borrowers defaulted. The problem worsened for the investors as home loans could easily be securitised and money kept on flowing in.

It affected.........

While in the U.S it has affected home equity loans, commercial estate, etc, in India it has led to a drastic fall of sensex. To make good of their losses, the U.S sold most of its investments in India. India bought it because the amount of buying was much less than the amount of selling. Had that not been a case, image of U.S is so good in the mind of Indians that we would have bought it even otherwise.