Sunday, September 16, 2007

Sub prime lending and the crisis

A lot of talk has been going on about this particular issue which seems to have put the global financial markets in a tizzy. It all began in the United states around the fag end of 2006. In some sense it was a particularly fitting pin to prick the housing bubble which created unsustainable rises in housing prices. This was a big bubble.. a huge bubble..the real estate market is used to frequent ups and downs but this bubble made historical booms look like froth from a bottle of flat beer.

In the background of this crisis and housing boom, we have a set of clever bankers and hedge funds, making full use of the speculative spirits in the air. They decide to, gripped by an uncontrollable bout of brotherly love, extend credit to anybody who comes asking for it, regardless of their credit history, criminal record, employment status etc.

Why, you may ask do these friendly bankers do this? Well, these customers of theirs who otherwise have no access credit would be willing to deal with higher interest rates.In addition, these obligations got collateralized, so the sub prime lenders and financial institutions would pool many mortgages, and sell a quantity of bonds whose principal value is less than the value of the underlying pool of mortgages. People would line up to buy these bonds because they would be thinking "Hey, there's a lot of collateral in this CMO, so even if a few guys default I'm good". On the other hand we have these borrowers who would find it hard to repay their loans, buckling under the pressure and left with no alternative but to default.

Unfortunately however, the buyers of these bonds didn't realize just how friendly these bankers were and the cascading effect of credit default. A whole lot of guys defaulted. As a result we have prices of $6.5 trillion worth of obligations crashing overnight. Now there are fears of the spread of such a crash to other parts of the mortgage sector (non-sub-prime), other sectors and the effect it would have on the US economy as a whole.

This was clever. This was a situation of business innovation really obscuring the bigger picture. Now however, there are reports that this is going to remain a localised phenomenon. It will still remain a good lesson for economies who get overly excited at the sight of an economic boom.

3 comments:

Unknown said...

Interesting stuff to read! Keep up the good work.

The dismal blogger said...

Thank you, Hard. I hope to hear your opinions about these matters as well and I will keep posting.

The dismal blogger said...
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