Sub-Prime Crisis is something that has hogged the limelight for quite some time now, and fortunately for all of us its effect is subsiding. But wait, nothing can be said for sure about the future. Even though we have financial pundits who are highly optimistic about the financial situation we cannot be sure.
Definition: So what exactly for the layman is the sub-prime crisis? The term does not tell us much about the same save for the ‘crisis’ part. The ‘Sub-Prime’ part defines the quality of the borrowers and as is evident they have weakened credit histories and a greater risk of loan default than prime borrowers. But then why do lenders loan credit at all to the sub-prime borrowers. It is here that the notion of High Risk High Gain comes into play. Since the credit-worthiness of the borrower is something that cannot be relied upon, so in many case strict lending rules make it difficult for them to get loans. But in case of sub-prime loans, the rates of interests are high, but the sub-prime borrowers do get the requisite loans. Since this is the only type of loan available to many a sub-prime borrower, they go for it. And the lender has the obvious benefit if his loan I repaid.
So who are sub-prime borrowers?
The following is a broad classification of sub-prime borrowers
1. The borrower has a limited debt experience (so the lender’s assessor simply does not know, and assumes the worst).
2. The borrower does not possess any property assets could be used as security (for the lender to sell in case of default).
3. The borrower has an excessive debt (the known income of the individual or family is unlikely to be enough to pay living expenses + interest + repayment),
4. Other defaulters of the sort.
5. In some cases student loans are also categorized as sub-prime loans because if a high number of school drop-out especially in the United States
Historically the percentage of sub-prime loans as of the total number of loan has hovered around 8% which was decent enough. But in the late 2000s this grew to almost 20%. This along with several other factors was part of the broader trend of lowered standards of lending and higher risk mortgage products. Further, U.S. households had become increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related. All these were factors that led to the crisis. The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.[/toggle]
The impact of the crisis was severe, not only in the United States but in the entire world. The major impact was however on the American Public and the American Companies. Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. Housing prices dropped significantly, assets declined, sales decline especially of the automobile industry leading to higher unemployment. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007.[/toggle]
Impact on India:
The sub-prime crisis has led to near loss of confidence in the American Stock Markets, and this has accentuated the credit crunch. In order to consolidate their respective balance sheets in the United States, these banks are unwinding positions in developing markets hence causing down swing in these markets. . A simple case in point was the intraday 1400 points fall on the BSE in January 2008 that was brought about by Citi Bank unwinding its position in many front line stocks in India.
The near recession situation in the USA has led to a loss of demand for Indian exports hence loss of export earnings for India Not only is there a loss in the goods sector, but the IT sector is also feeling the pinch. Banks and other financial institutions are on a job slashing spree to cut costs. This means that many jobs in India are at stake because these institutions have their BPO’s in India. So the first jobs to go will be the low end Indian BPO jobs leading to increased unemployment in India. There will be serious implications for the banking sector as well. The sub-prime crisis has meant that the Indian banks have to follow stricter norms while disbursing loans to the people. These tighter norms could prove to be counter cyclical. The argument is this‐people will be asked to provide collateral for the loans given to them. Anybody who is unable to furnish the collateral will be denied a loan. This policy will exclude a majority of the population from institutional sources of credit, thereby affecting growth negatively.
Response to the crises:
In the United States specifically Federal Reserve Chairman Ben Bernanke stated in early 2008: “Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy.”
In other areas and in the US the general strategy has been the following.
Government has taken several steps to ensure the economy fights back and the main aim behind the bailout plan by the government is to purchase the bulk auctions which banks would sell to recover their loans. The government is trying to control the market by supporting borrowers and purchasing loans from banks to ease the position. The crisis is way beyond control as the banks are following a cautious approach and not extending further loans which results in government taking complete control of the credit market. This will take much time to stabilize and the government has taken full control to stop the crisis. The government has made some plans for the borrowers to make them come on the payment track. The government is working on methods to solve the sub-prime crisis. The sub-prime crisis is a financial crunch which will take time to resolve and the increasing housing loan rates have triggered this problem. The government is planning to control the credit market and support both homeowners and banks.