US Mortgage Sub-Prime Crisis
May 9th, 2008
Heard a lot!! Well I bet you must have…So let’s try and understand these words in detail…
Definitions
1. Mortgage – You own a house which is financed by a bank or a financial institution and make monthly payments to them for a specified period of time.
2. Sub-prime customers – Customers who had a low score or a credit rating by virtue of being irregular in making payments for different products and tend to be less credit worthy.
3. Credit scores – indicators of past performance on repayments on a loan.
4. Crisis – Disaster which stuck and forms the part of the story from here on!
Million $ question - What actually happened?
As per the definition explained above – the set of customers defined as Sub-prime were approached by the leading banks and financial institutions in US post speeches from prominent politicians in the US to take up on consumerism – go out and spend.
This started the rat race for acquiring maximum customers who had derogatory history and had very low scores and wouldn’t have had got a loan otherwise. So, a lot of these companies rebuilt their strategies and went full on in the market for acquiring these set of new customers who earlier never had the potential but now they seemed God.
As per the Credit strategy – higher the risk higher the interest rates! So, these class of customers with very low score who had marginal incomes with low job stability and tendency to default much higher than others (prime customers) were offered Mortgage loans priced a lot higher than the customers who had good scores. As per the industry definition this is known as “Risk based pricing”.
These set of customers were more than happy on getting a Mortgage loan for a house that they had dreamt of but failed to understand the consequences. Most of these customers were unaware of:
A. The complete legal documentation signed by them – what does it meant!
B. The adjustable rates mortgages – what does this mean too?
C. Consequences if not made full timely payments.
D. The foreclosure charges, penal charges etc. which too were on a higher side.
All these customers were caught unaware and by the time they realized it was too late. Their homes were already on the footsteps outside the courthouse for a bid to be sold to the highest bidder.
So how did it happen?
As we have read till now – the sub prime category of customers have a higher tendency to default and their ignorance of understanding the financial gimmick they were played on; this is how it happened.
These customers were first made to pay at higher interest rates which meant more outflow of installment amount form the limited income sources they had. What they did fail to understand was that their loans were not only priced higher initially but at an adjustable rate which meant that their installments or EMI amount will increase over a period of time. On an average the EMI amount which these customers started off initially was doubled which was unaffordable at their current levels. So with this started off with the defaults and foreclosures activities. Many of the customers hit by this had been on an adjustable rate mortgage and the ones who were not – were either out of job or were not able to shell out the EMI amount every month since they now find it more difficult to sustain it on an ongoing basis. There used to be a concept called as Red Lines in the US which were drawn on a particular block or township – which meant no lending in this area. This too was overlooked and the companies who used to completely not even consider it started to go fully into these areas and started making loans. Some customers tried to foreclose their loans but since they were classified as the “Sub-prime” customers they had huge prepayment penalties and penal charges which made them totally unaffordable to even foreclose them. So, these customers who had limited means somehow managed to pay the financial institutions for some time and when they realize they can’t afford it no more have only one option now…….Move out of their homes as the payments are overdue and they can’t even foreclose owing to the higher charges.
This inability to pay was known from the very beginning and had to happen. So, no job, no income, bad credit history, red line area – No problems! We’ll finance you anyways …Take a loan and spread “CONSUMERISM”
Not only have the customers suffered!
Sub-prime category of customers whom the financial institutions knew would default at a higher rate were made to sign agreements which they never understood completely; to make up for their targets, revenues on account of accelerated growth in this segment where they were charging a bombshell from the sub prime clientele. All seem to go good when the bubble started to take shape and busted out-casting the pace at which at was grown and hell broke loose. Customers were made to give up their homes, property prices in the US came down crashing on account of excess Supply; taking a toll on the overall property market, companies who had provided these loans – started to report the write downs in their books as the customers did not have the money to repay, fingers pointed towards the Top-Brass of these companies and had no option else to step down from the top jobs. This did not end here and there’s still more to come as per the experts. Since, a lot of these companies have global presence – the huge write-offs meant cost rationalization for the entire group – which meant everyone in the entire group in different countries had to be affected by the story which took birth in the US. So, job cuts, no wage hikes, selling out businesses etc. started to happen and had a wide spread global effect. A lot has been seen already as there is a lot of stress currently as well. Stock prices are a fair indicative and markets do react. EPS (Earnings per share) of some companies went down to the extent of worse in history for their companies which has resulted in pointing out the fact that there is a lot to be done before winning over market sentiments again. Since, a lot of investors had been provided Mortgages Backed Securities (MBS) which meant securing the future repayments from the customers and the defaults; they faced huge losses as the mortgage backed asset value declined thus resulting in stock market crashes in a lot of countries.
Lessons from the US sub-prime crisis
Draw your boundaries clearly and know who to give a loan else be ready for the circular effect.
You provide a loan to someone who does not deserve it by charging him higher rates which he sustains only temporarily and defaults in due course and you have no other option besides to take up his house. This results in writing down and taking loss from that account. Customer who somehow repaid some portion has wasted those payments completely which he thought was building his home. Since more write offs for a company means downsizing its work force. So unemployment increases and results in less spending by the people, inflation/deflation start to happen due to excess or low demand, stock markets crash, huge losses or bankruptcies declared by firms – so all this forms a part of a recession.
Idea is to make easy loans available to people who can afford it and cannot be let down by it.
After all – It’s easier to source than to collect!!
Amandeep Singh Kohli
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June 7th, 2008 at 7:32 am
Good one Sir…. Basics of the issue have been highlighted…Really interesting to read. Keep me posted in future of such write ups…All the very best…
October 14th, 2008 at 3:09 pm
A very well written article based on deep study with regard to sub prime crisis.