US subprime horror: Worst may be yet to come

Part I: When America sneezes India catches cold

So why did the subprime home loan crisis in the United States happen? The one word answer for it is 'securitisation.'

As we saw in the article, When America sneezes India catches cold, it all starts with an American with a poor credit rating wanting a home loan. A normal bank will not give him a home loan. The reason is very obvious, with his poor credit rating the chances of his defaulting on the loan are very high. And no bank likes to take on customers who are likely to default.

Here is where institutions who have a good credit rating and are willing to take some amount of risk, come in. They borrow money from banks and lend it to Americans who have a bad credit rating. They divide this loan, into a lot of small tranches and give it out as home loans to Americans who do not have a good credit rating and to whom the bank will not give a home loan directly.

They give out the loan at a rate of interest which is obviously higher than the rate at which they had 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, they try and ensure that even if a few of them default, the overall position is not affected much. 

The institution giving out the home loans in the subprime market does not stop here. It does not wait for the principal and the interest on the subprime home loans to be repaid, so that it can repay the loan it has taken from the bank. 

It 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. The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors who buy these financial securities. 

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

This part we had already seen in the last article. The entire problem arose because institutions giving out subprime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution. Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan.  

Given the fact that institutions giving out the loan do not take the risk, their incentive is in just giving out the loan. Whether the individual taking the home loan has the capacity to repay the loan, isn't their problem. Hence chances are that proper due diligence to give out the home loan is not done and loans are given out to individuals who are more likely to default.

Other than this, greater the amount of loan the institution gives out, greater is the amount it can securitise and, hence, greater the amount of money it can earn.

After borrowers started defaulting, it has come to light that institutions giving out loans in the subprime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans. As explained above, by giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and hence earn more money.

These loans were floating rate home loans, once interest rates started to go up the equated monthly installment (EMI) to repay these loans, went up as well. The borrowers who had bad credit ratings in the first place, could not service the higher EMIs and started defaulting.

Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in. Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money, does not have any inhibitions in lending out money again.

And so the story continues. Till, that is, one fine day when borrowers stop repaying. Investors who bought the financial securities cannot be serviced. So to make up their losses in the subprime market in the United States, they go out and sell their investments in emerging markets like India. Since the amount of selling in the market far outweighs the amount of buying, emerging markets like India have been falling.

A lot of the floating rate home loans will be reset in the month of August. When floating rate loans are reset, interest rates either go up or come down. In the current situation interest rates are likely to go up. Given this, there might be more defaults in the subprime home loan markets and hence more volatility in stock markets around the world. The worst might be still to come.