Of Recession and Sub-prime crisis

So with the USA officially declaring today that it has been in a recession since December 2007, and the global meltdown in the process, I thought of writing a few words on certain roots of this crisis. Say a slight technical informative view.

It all began with sub-prime loans. Before you scratch your head, let me explain. Sub-prime loans can be described as loans that are given to borrowers who are perceived to have high credit risk, mainly coz they lack a strong credit history or have other characteristics that are associated with high probabilities of default. They are a lower class of loans compared to prime loans.

This was an underserved market in the US more than two decades ago, but it gained interest of many lenders in the mid 1990s, due to market innovations that reduced costs for lenders of assessing and pricing risks. Basically, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. Another factor for the splurge in sub-prime lending was due to regulatory changes. New regulations made it easier for lenders (banks) to sell of their mortgages to other investors on the secondary mortgage market. This is what securitization is. Very simply, a bank would give mortgage loans to homeowners. Thus the homeowner will be paying a certain monthly interest to the bank. Now to give out the initial loan the bank should have money. How does the bank get this money? They pool all the mortgage loans into one security (imagine a stock that reflects the pricing of the loan pool) and sell it to investors (like selling stocks). In return, these investors receive a certain return from the repayments bank receives from the homeowners. The risk here is that the investors take on the high returns as well as the risk of defaulted pay by the homeowners. The higher risk you take the higher the return. The bank is a mere broker earning commission in the transaction.

Homeowners ---interest + monthly repayments--- > Lender/Broker ---bond payments(returns)------> Investor (Mortgage bond market)

Homeowners < ---Loan to buy house----- Lender/Broker <---buy mortgage security (bond)----- Investor (Mortgage bond market)

The important thing is that the interest rates that are paid by the homeowners are not fixed. It’s related to US Federal Fund rate and adjustable accordingly. At the time of the sub-prime boom, these rates were low. Thus, the low credit rated homebuyers could buy their dream houses, the banks (lenders) got their commission and investors were taking on high returns from the high risk they were taking. There was no sign of the property market going down, no sigh of recession, everybody was happy.

So how did this happy bubble burst?
The housing market from what I know. The house-builders built too many houses and prices slowly went down as many houses remained unsold. annnd BOOM! The sub-prime crisis hit the housing market in US in 2007, with high inflation, increasing interest rates and declining real-estate prices. In short, the crisis refers to various credit problems faced by the sub-prime lenders and other market participants.

The adjustable sub-prime lending rates increased with rising Federal Fund rates, and the homeowners found it difficult to repay the suddenly higher monthly interest. Defaulting began. As the houses (that were bought on the loan) were the collateral for default the banks/lenders ended up having a lot of properties in their hands. What's more, they couldn’t sell it back at profit to the market, since the property market was on a downward trend. With increased borrowing rates, people became more cautious in buying real estate thereby slowing down money flow and resulting in holding of assets by the lending companies.

With the declining housing prices, the value of their mortgage backed securities started declining in the secondary securities market and the investing companies (such as CityGroup, Merrill Lynch and, HSBC) with their high uncovered exposure to the crisis started losing in on their investments.

With the news of the market downturn spreading, these companies’ stock prices and revenue took a negative turn, largely affecting stock markets all over the world. Some of these mortgage backed securities prices went down to zero, absolutely no worth, and several big investors lost billions (imagine a stock you invested in at USD40 come down to zero). For example, Merrill Lynch, still plagued by declines in the value of assets such as mortgages, reports an estimated net loss of $1.96 billion for its 2008 first quarter and Citigroup reports similar loses due to sub-prime exposures ( off topic, I can't find the references right now, can I get sued by this? ).

Thus, here we are, an economic crisis all around, and poor me jobless at home trying to enlighten atleast one reader. I did try to make it less technical yet informative as possible.
A more elaborate and expert account can be found here.

Hmm. I should be grateful I haven’t suddenly lost my home, or left wondering how I am going to pay for the next meal.
But still. damn it.