Prakash: Hey, wats this subprime crisis in USA all about?
Suresh: Oh, this situation has got the Global superpower US & A in a state of jeopardy. let me explain what caused it. The root cause for it is Mortgage based securities which is related to what we call the subprime loans. It was mainly caused due to large amount of dafaulters in loan repayment.
Prakash: Hey hey, its all overhead transmission. Make it simple.
Suresh: okay, see there are some categories of home loans based on the risk for the lender (known as credit risk). on a broader perspective i can say , subprime and prime loans. Subprime loans provide borrowers with little or no income, little or no equity with loans based on variable-rate mortgages. Basically the regulations and guidelines before lending loans were relaxed to a greater extent.
Prakash: Ok, go on. But anyhow, What is variable rate mortgage?
Suresh: Let me complete. See consider our friend jandy in US seeks a loan for his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan. Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments.But lo, there enters a second American usually a robust financial institution who has good credit rating and is willing to take on some amount of risk. Given his good credit rating, the bank is willing to give the second American a loan. The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans including our friend at a much higher rate than the rate at which he borrowed money from the bank who do not have a great credit rating and to whom the bank would not have given a home loan in the first place. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market.
Prakash: things are starting to make sense here.
Suresh: Also by giving out a home loan to lots of individuals, the second American is trying to reduce chances of defaults. The institution giving out loans in the sub-prime market does not stop here. It goes ahead and 'securitises' these loans. Securitisation means 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. Many institutions like the 'second American' in our story sold complicated securities that were backed by debt which was very risky. Prakash: But how are these deposits repaid?
Suresh: The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors.The institution giving out the sub-prime loans takes the money that it gets by 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. Or so it would have seemed.
Prakash: Oh lets have a cup of tea at nathu's in the meantime. we can continue it afterwards.
Suresh: While we return from the tea stall, pour in your views/queries/doubts/questions for part 1 mentioned herewith. Oh... its so cold..
Suresh: Oh, this situation has got the Global superpower US & A in a state of jeopardy. let me explain what caused it. The root cause for it is Mortgage based securities which is related to what we call the subprime loans. It was mainly caused due to large amount of dafaulters in loan repayment.
Prakash: Hey hey, its all overhead transmission. Make it simple.
Suresh: okay, see there are some categories of home loans based on the risk for the lender (known as credit risk). on a broader perspective i can say , subprime and prime loans. Subprime loans provide borrowers with little or no income, little or no equity with loans based on variable-rate mortgages. Basically the regulations and guidelines before lending loans were relaxed to a greater extent.
Prakash: Ok, go on. But anyhow, What is variable rate mortgage?
Suresh: Let me complete. See consider our friend jandy in US seeks a loan for his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan. Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments.But lo, there enters a second American usually a robust financial institution who has good credit rating and is willing to take on some amount of risk. Given his good credit rating, the bank is willing to give the second American a loan. The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans including our friend at a much higher rate than the rate at which he borrowed money from the bank who do not have a great credit rating and to whom the bank would not have given a home loan in the first place. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market.
Prakash: things are starting to make sense here.
Suresh: Also by giving out a home loan to lots of individuals, the second American is trying to reduce chances of defaults. The institution giving out loans in the sub-prime market does not stop here. It goes ahead and 'securitises' these loans. Securitisation means 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. Many institutions like the 'second American' in our story sold complicated securities that were backed by debt which was very risky. Prakash: But how are these deposits repaid?
Suresh: The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors.The institution giving out the sub-prime loans takes the money that it gets by 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. Or so it would have seemed.
Prakash: Oh lets have a cup of tea at nathu's in the meantime. we can continue it afterwards.
Suresh: While we return from the tea stall, pour in your views/queries/doubts/questions for part 1 mentioned herewith. Oh... its so cold..
6 comments:
Indian names no....
check this out also
http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1
Jandi,
Nice approach...
i am waiting for the second part.....
Dost you should remove this approval part for comments on ur blogs.Otherwise your efforts for such writings will go waste..
Ok veenu, the change is done.
jandiii,
please elaborate the EMI stuff, the securitisation in more elaborate form ... i havnt reached the clarity of the topic... somethings missing.. newaz wil wait for the next post
@ nitesh: very helpful finding on the topic. A picture is better than thousand words indeed.
@ Andy: please go through the part 2 . hope it answer your query. tell me if you need further explanations.
Post a Comment