Subprime Simplified

shared by Ateet Bansal (PGP-2007-2009)

Q1. What is a subprime loan?

A subprime loan is made to customers who typically have low credit scores and histories of payment defaults or bankruptcies. Subprime offers the opportunity for borrowers with less than ideal credit standing to gain access to funds. Borrowers use this credit to purchase homes, or finance other forms of spending such as purchasing a car, paying for living expenses, housing loan, or even paying down a high interest credit card.

However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher rates.


Q2. What is the risk to this kind of lending and borrowing arrangement?

Capital markets operate on the basic premise of risk versus reward. Investors who bet on stocks are taking a higher risk in the hope of higher returns, compared to investors who invest in risk-free government bonds, but are content with low returns.

The same goes for loans. Less creditworthy sub-prime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a regular borrower for the same loan.


Q3. What the events that can lead to a crisis in this loan segment?

Banks which lend to sub-prime customers, securitize the interest receivables from these loans, and sell the bonds to financial investors. These investors could be hedge funds, pension funds, insurance companies or any other institutional investor.

When interest rates shoot up, customers are unable to keep up with mortgage and loan repayments, and start defaulting. This means that the interest payments due on the bonds cannot be serviced.

A steep rise in the rate of sub-prime mortgage foreclosures has caused more than two dozen sub-prime mortgage lenders, including some of the biggest US sub-prime lender to fail or file for bankruptcy, threatening broader impacts on the US housing market and economy.

Ratings agency downgrades of subprime-related securities have gained momentum in recent weeks. The mounting problems could force ratings agencies to downgrade billions of dollars of mortgage securities below investment grade, a move that would in turn force many investors to sell their holdings and exacerbate the spiral of losses.


Q4. Why have are other markets been hit by the ongoing subprime loan crisis?

Anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values, making homeowners feel less wealthy and thus contributing to a gradual decline in spending that may weaken the US economy.

Many emerging market economies are heavily dependant on the US for export revenues. A slowdown in the US economy could in turn trigger a slowdown in countries relying on it.

But even the stock markets of countries that do not export goods to US in a big way have been hit. This is because a hedge fund or any other institutional investor that has put money in mortgage- backed securities in the US is usually invested in other markets as well. So, when these funds suffer huge losses because of the subprime loan crisis, they try to offset it by booking profits in other markets.

The leveraged positions taken by these investors would suck out liquidity from the system. How much would emerging markets like India be impacted would depend on the crisis' severity