When Americans sneeze India catches cold

The Bombay Stock Exchange Sensitive Index or Sensex as it is more popularly known fell by 643 pointson Thursday, August 16. Various stock market experts have blamed the subprime crisis in the United States. So what is this subprime crisis? And why is it having such a decisive impact on the Indian stock market? To know more read on.

Essentially it all starts with an American wanting a home loan. But there is a slight problem. He doesn't have a great credit rating. So a bank will not give him a home loan.  Enter a second American who has a good credit rating and is willing to take on some amount of risk. Given his good credit rating the bank is willing to give him a loan. The bank gives the second American a loan at a certain rate of interest.

The second American divides this loan, into a lot of small tranches and gives it out as home loans to lots of other Americans like the first American, who do not have a great credit rating and to whom the bank will not give a home loan.

He gives out a loan at a rate of interest at a higher rate of interest than the rate he has borrowed from the bank. This higher rate is referred to as the subprime rate and this home loan market is referred to as the subprime home loan market. Also by giving out a home loan to lots of individuals, he ensures, that even if a few of them default, his overall position is not affected much. 

The question that crops up here is, if this home loan market is subprime, what is prime? The prime home loan market essentially refers to individuals who have good credit ratings and to whom the banks lend directly.

Now back to the subprime market. The individual giving out loans in the subprime market does not stop here. He does not wait for the principal and the interest on the subprime home loans to be repaid, so that he can repay his loan to the bank, which has given him the loan.

What does he do? He goes ahead and securitises these loans. Securitisation essentially involves, converting these home loans into financial securities, which promise to pay a certain rate of interest.

These financial securities are then sold to big institutional investors. And how are these investors repaid? The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors. 

The individual giving out the subprime loans, takes the money that he gets from selling the financial securities and passes it on to the bank, he had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Well not really.

The subprime home loans were given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the EMIs that need to be paid to service these loans go up as well.

The higher EMIs hit the subprime borrowers hard. A lot of them, given their poor credit rating, defaulted. Once, more and more subprime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses.

Well, that still does not explain, why stock markets in India, fell?

Institutional investors who had invested in securitised paper from the subprime home loan market, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world.

Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion. In order to invest more money in the US, money had to come in from somewhere.

And this money came in from emerging markets like India, where their investments have been doing well. So these big institutional investors, to make good of their losses on the subprime market, have been selling their investments in India and other emerging markets. Since the amount of selling in the market, far overweighs the amount of buying, the Sensex has been on a falling spree.

And that explains the title of this piece 'When Americans sneeze India catches cold'.