Too many houses,too little money
Mar 25, 2014
Source : Business Standard

 

DELHI: For over a decade before the crisis actually hit, especially between 2002 and 2004, a lot of investors from around the world were parking their money with banks in the U.S. for very low interest rates. Money was so widely available, and so cheap, that banks started lending them to individuals as home loans (housing mortgages). Since banks didn’t know what to do with all the spare cash lying around, in many cases, they lent this money to people who wouldn’t be able to pay back.

For example, if your father earns Rs 1,00,000 a year and wants a loan, the bank would never lend him more than what he earns – that is, the loan will definitely be lower than Rs 1,00,000. But imagine a bank lending him Rs 1,30,000 – there’s no way your father would be able to repay that money because he isn’t even earning that much, let alone setting money aside to pay for food, petrol bills and your school fees.

But the banks in the U.S. were doing just that and many U.S. citizens had taken on loans that they weren’t capable of paying back. These people were called ‘subprime borrowers’ – that is, a borrower who does not meet the prime standards of getting a loan or is below (‘sub’) those standards.

While these loans were being made, two other events were happening:

One, as people found it really easy to get home loans, the demand for new homes shot up. The real estate market went into a frenzy and so many new homes were built that eventually, there were more homes than people willing to buy them.

Two, banks realised that instead of waiting for borrowers to pay their loans back (they still believed they would), they could sell these loans as investment products and pocket the money right then. So they created a product called a mortgage-backed security. For example, instead of waiting to receive payments from borrowers A,B,C for the home loans they had taken from Bank X, the bank pooled these three loans together (let’s say it was worth $10,000) and sold it to an investor Y for $9000. When it was time to repay the loans, A,B and C would now have to pay $10,000 to Y instead of Bank X.

These mortgage-backed securities became very popular financial instruments; so much that banks started lending to even more subprime borrowers just so they could create and sell more of these securities.

Obviously, none of this is very healthy. When the time for repayment came around, most borrowers found they couldn’t pay (remember, they weren’t even earning enough money to repay their loans) and let the banks take their homes away. Usually, a bank would sell the house and use the money to cover the cost of the loan. But because lots of homes were being taken away by banks now, suddenly, there was an oversupply of homes in the real estate market and no buyers and home prices crashed.

Both borrowers and investors (who were, quite often, other departments of the banks themselves) who had bought these securities lost all of their money. The US subprime mortgage crisis had started.

In 2006, bankers and investors had realised that their system of finance was going to blow up. Lehman Brothers, one of the biggest banks in the world at the time, became bankrupt in 2008.

The crisis did not affect India because Indian banks had not invested in the U.S. housing market through the mortgage-backed securities. But as banks and businesses in the U.S. went into recession-mode, Indian companies who had clients in the U.S. were hit. For example, IT firms like Infosys and Wipro lost a lot of business once the mortgage crisis imploded.

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