The American Sub-prime crisis

1. Trigger- central bank reduced lending rates and bond yields to 1% in 2004 as
part of its plan for reviving the economy after the dot com bust and 9/11
2. This in turn led banks to borrow more money and lend out more
3. Simultaneously, this also led to investors (American and foreign) to favor
other investments than American treasury bonds due to their low return rate.
4. The excess liquidity with the banks translated into greater lending, thus
providing easy access of liquidity for big purchases such as houses, cars, etc.
5. At the same time, the investors mentioned above recognized the housing
sector as the sector they wanted to invest in due to its characteristic of
continuous appreciation and thus sure-shot returns. It appeared to be a lowrisk and high-return investment.
6. Therefore, to provide a profitable investment instrument to investors, banks
began clubbing thousands of mortgages into instruments called Mortgage
backed securities and selling them to investors (these securities also
received AAA rating from credit-rating agencies such as Moodys and S&P).
The win-win logic being:
a. In case the borrower repaid the debt, the bank would make a profit
through the interest
b. In case the borrower defaulted, the bank would get the collateral (the
house) and then sell it off to someone else and make a profit
7. While this was going on, housing prices kept rising steadily in the US. As the
safe loans (i.e. loans to customers with good credit ratings) dried-up, banks
started handing out loans to risky customers (people with bad credit history
or unsteady jobs), or sub-prime lending to meet the demand of investors for
more such securities. Therefore, millions of people in the US bought houses
they could ill-afford or not afford at all, and bought them only because at that
point they thought they could repay the EMIs at the low interest. CDOs
(Collateralized Debt Obligations) were an ever riskier form of securities and
consisted primarily of such sub-prime mortgages.
8. However, soon after, such sub-prime customers started defaulting on their
payments. The banks now found themselves with an excessive inventory of
houses with no buyers in sight. As this situation arrived, housing prices
crashed, and buyers who were repaying their EMIs also realized that they
were paying the banks much more than what their house was now worth
e.g. I was paying $300,000 for a house that now cost only $90,000! Therefore
these customers too stopped their repayments. This in turn aggravated the
existing crisis and led to the precipitation of the sub-prime crisis of 2008.