Friday, October 31, 2008

On subprime loans and securitization

This post follows the request from two of our readers in the shout-box on Indian Current Affairs.

Though we have covered it quite a few times in our blogs, I take this opportunity again for the benefit of newcomers to our blogs.

The term 'subprime loan' refers to loans advanced to subprime borrowers.  Subprime refers to the borrower's classification.  A borrower is classified as subprime when her creditworthiness is less than perfect.  That is her ability to repay the loans given her is fraught with high risk.  Therefore, the rate of interest on loans given to her attract higher rates and usually prepayment penalties.

Securitization of these subprime loans means pooling and repackaging these loans into securities that are sold to investors who are willing to buy them.  Because the lender has already invested his money in giving loans to subprime borrowers, by securitizing them, what he does is raise more money on the strength of the asset (subprime loans given by him) from willing investors.

Why would investors be interested in purchasing these securities which represent subprime loans?  Because they have the risk appetite.  They think that they will earn more return for their investment.  They think that the bank which has securitized the assets is so reputable that it will never palm off a bad security to them for investment etc.

Securitization has reportedly allowed banks and the original investors to raise about $10.50 trillion in the US alone.  In Europe it has reportedly enabled raising of $2.25 trillion in finance.  These figures pertain to the period up to second quarter of 2008.

Has it become a bad word now?  How did it lead to the present liquidity crisis?
Securitization per se is not bad.  What has made things worse for the globe is the fact that the banks which sold these asset backed securities (subprime loan backed securities) have indulged in all possible dirty tricks while packaging these securities.  They have mixed these poor quality assets with good quality assets (i.e., loans to prime borrowers) and have inflated the possible returns to investors and backed their claims with excellent ratings (AAA ratings and the like) from credit rating agencies.  A AAA rating from a reputable credit rating agency means that the asset is very good and the payment default -- of either the interest or the principal -- is NIL.  Such ratings have lulled the investors into making huge investments into these worthless securities. 

Okay.  So where was the problem? 
The problem arose when the subprime borrowers were not able to pay their loan instalments properly and well in time.  Because it is only then that the lenders will be able to make money.  Because the lender, in the meantime had securitized these loans, it is the ultimate purchaser or investor in these securities that suffered, the credit ratings notwithstanding.  So, the investors started demanding their money back by surrendering these securities to the banks.  That is how the banks ended up receiving a double whammy.  There was tremendous pressure for money.  Their securities investors started demanding money and the borrowers are failing to pay their loan instalments.  The bank was not able to raise more money because the other banks sensed that it is in trouble and refused to lend it money.  This resulted in the liquidity crisis -- i.e., banks refused to lend to each other because they are afraid that they will not be repaid their monies.

Hope this answers the questions posed in the shout-box.


Shyam said...

Excellent description of the sub-prime crisis.
Exactly what I was looking for

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