The Sub Prime Balloon | Trade Samaritan

The Sub Prime Balloon

Sub prime crisis continues to feature in numerous books, journals and blogs almost every single day. Out of all the brilliant reads available on this subject, for further reading we would certainly recommend reading Michael Lewis’s mesmerizing narration and description of this gigantic event.

Sub prime crisis deserves a place in every Trade and Finance blog in the universe so Trade Samaritan is paying its due respect.

If we study the crisis under microscope we will observe that there are multiple vicious cycles responsible for increasing the breath and depth of the crisis. Let us study each phenomenon that occurred in 2007-2008 financial crisis step by step. In this article we will focus more on the root causes and the occurrence of the phenomenon and not than the after effect.

Sub prime loans

At the bottom of the balloon lie a big fat pile of sub prime loans. In simple words, sub prime loan is a type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. The basic features of this type of a loan are:

  1. Higher interest rates
  2. Poor quality collateral
  3. Borrowers have weakened credit history
  4. Reduced repayment capacity if weighed on a debt-income ratio
  5. Less favorable terms to compensate for the higher risk being borne by the lender

Needless to mention that such loans have a higher risk of default as compared to prime borrowers. Sub prime lending in the U.S peaked from 2004 to 2006. U.S._Home_Ownership_and_Subprime_Origination_Share

Mortgage lenders went over board with sub prime lending as these loans were disbursed with a higher rate of interest.

On the other hand, the borrowers jumped in for the loan offer without taking into consideration the affordability. There are mind boggling  instances, for example child’s day care maid earning wages on an hourly basis had acquired a lavish house as compared to her employer.

Securitization (Mortgage Backed Securities)

Now that sub prime mortgage product was spreading like a fire in forest, lenders started to securitize their loan portfolios.

Under securitization, mortgages are combined into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.

Now the lending institution acts like a middleman, and the investor/buyer of the security is actually financing the home buyer. And the interest and the principal payments are re-directed to the investors. Investors were more than willing to invest in MBS (mortgage backed securities) as the rate of interest they were supposed to earn was more than ordinary investments.  The credit rating agencies blessed most of the mortgage backed securities with AAA rating. This increasing demand was like fuel to fire and the sub prime loan volume skyrocketed.

Housing bubble

This is most interesting of all phases, this is where the bubble was formed. By 2006 housing market was flourishing. The demand for mortgage as well for mortgage backed securities kept on going up. Credit rating agencies continued to rate the securities positively as the defaults hadn’t kicked in. The rising demand for houses drove the prices up and whenever the borrowers had a difficulty in paying the installments, they could easily draw another loan on the same house as the price of their house had risen. So they were using debt to pay debt which is fundamentally incorrect and bound to hurt at some point. On the other hand,  lending institutions were facing huge demand for mortgage backed securities and they were focused more on quantity than quality. Most of the lending companies went on a lending spree, the lending standards were lax.

 Actual crisis and vicious circles

Sub prime mortgages, housing demand and mortgage backed securities shot up however the basic household income remained static. And it happened, housing prices reached a point so high that the only way left was way down, in the mean time borrowers started defaulting on their loan installments back to back. One default led to the other, chain reaction led to huge losses and the fall of lenders and investors. These defaults and foreclosures increased the number of houses available in the market. Prices started to fall drastically as the supply was way more than the demand.

There were two prominent chain reactions going on in the markets at that time.

Declining housing prices triggered the first one whereas the foreclosures triggered the second one.

The diagram explains the vicious circles of foreclosures and bank instability.

subprime crisis cycles

Cycle 1: Voluntary and involuntary foreclosures increased the supply of homes, which lowered the home prices further creating a negative equity. Negative equity happens when the market value of the house goes below the mortgage value of the same house. In this case the gap was very high as the prices had sky rocketed in the earlier phase and borrowers had refinanced in order to get money which was diverted for payment of the original mortgage and consumer spending.

Cycle 2: Foreclosures reduced the cash flow of the banks and the value of Mortgage Backed Securities. Banks and Financial institutions started to incur huge losses and their lending capacity decreased. This led to economic slow down and unemployment further increasing the foreclosures.

Again at a macro level, cycle of deterioration looked something like this.

subprime deterioration cycle

It was reported in August 2007 that the number of residential mortgage foreclosures jumped 9 percent from June to July 2007, surging a whopping 93 percent over July 2006. By March 2007, the U.S., sub prime mortgage industry had collapsed. More than 25 sub prime lenders had declared bankruptcy, announced significant losses or put themselves up for sale.

The sub prime meltdown affecting the United States went global when stock markets around the world plummeted on Jan. 21, 2008. U.S. markets were closed for Martin Luther King Jr. Day, but all the world’s other major economies experienced a sell-off. Stock prices fell more than 7 percent in Germany and India, 5.5 percent in Britain, 5.1 percent in China and 3.9 percent in Japan.

Finally, several economists and analysts have studied the sub prime crisis in detail thereby coming up with hundreds of theories, there are multiple causes such as lax lending policies, insufficient collateral, certain Government and Federal regulatory policies, securitization,  incorrect credit rating, banks, mortgage brokers and underwriters acting as middlemen only thereby least interested in the magnitude of risk involved and unwise borrowing. The adverse impact was not limited to the real estate industry, S&P 500 index dropped by 52% and stocks across 13 different industries plummeted. People and companies went broke, Lehman Brothers and Bear Stearns were declared as defunct. This meltdown was compared with the meltdown that occurred during WWI and WWII.