The Sub-Prime Drama

In India, banks have what is called a Benchmark Prime Lending Rate (BPLR) which is supposed to be the basic lending rate beyond which markups are added for borrowers with lower credit rating. Sub-PLR rates, i.e. rates lower than this BPLR, are offered only to the top class borrowers. In the USA, however, the best rates are offered to 'prime' borrowers and it is the sub (below) prime borrowers who are quoted rates with a premium or markup loaded, depending on their credit rating. Therefore, sub-prime refers to the (lower) quality of the borrower and this kind of borrower is usually charged a higher rate than a 'prime' (best) borrower. According to Wikipedia, subprime lending, also called B-Paper, near-prime, or second chance lending, is a general term that refers to the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. It is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and murky financial situations often associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself. Generally, subprime borrowers will display a range of credit risk characteristics that may include one or more of the following: i) Two or more loan payments paid past 60 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months; ii) Judgment, foreclosure, repossession, or non-payment of a loan in the prior 48 months; iii) Bankruptcy in the last 7 years; iv) Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 660 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood. About 21% of all mortgage originations from 2004 to 2006 were subprime, up from 9% between 1996 and 2004, as per chief economist for Moody's Investors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market. Many of the sub-prime mortgages were offered at special schemes offering below-market rates for the first few years of the mortgage but escalating thereafter. Consumers took these mortgages hoping that they could refinance them after a few years at an affordable interest rate. On the other side of these transactions, rapid developments in financial engineering allowed mortgages of all types to be packaged into pools and sold as high-yielding securities to a range of investors from third-tier banks to sophisticated hedge funds. Thus both homeowners and buyers of such securities got caught in this cycle. The tricky part was that after a few years, the artificially-low mortgage rates were required to reset to levels more in line with current market rates, which, in all likelihood, would be higher than the initial low rate levels. If house prices continued to increase, homeowners would still find it profitable to refinance their mortgages at affordable interest rate levels. However, beginning in late 2006, the realty bubble started to burst. Two events that were assumed to have a low probability in a booming market in fact happened: first, interest rates increased and second, home prices began falling. This led to sub-prime mortgages resetting at shockingly high rates, with homeowners missing payments and banks foreclosing accounts. On the other hand, banks and other financial institutions holding the mortgage-backed securities incurred losses and had to sell their assets. It is estimated that in the next five years $1 trillion in adjustable rate mortgages will reset, with sub-prime mortgages making up the majority. Resets of mortgages this year are estimated to occur at rates that are about four percentage points higher than the current rate on 30-year home loans. The virtuous cycle of mortgages turned sour. Banks and other institutions cut back their lending, not only for mortgage-related activities, but also for other activities, as liquidity fell. As the impact spread from the US to Europe and then globally, central banks rushed to inject liquidity into their respective markets in order to stem the tide. The US Federal Reserve Board announced a half a percentage point cut in the discount rate (the rate at which it lends to commercial banks) to 5.75 per cent on August 17 alongwith other measures to boost liquidity. The impact of this crisis has been felt as far as in India, where the stock market showed a steep fall from around mid-July'07 onwards (Sensex on 16 July'07 was 15,311, dropping to 14,195 by 17 Aug'07) as FIIs starting drawing down their investments in emerging markets to create enough cash for meeting their obligations in the US market. However, it is to RBI's credit that the early actions taken by it to stem credit to the booming real estate market in India by raising provisioning requirements and risk weights, besides warnings about heating up of this sector, stopped banks from overextending themselves to this sector like US banks. Rising property rates as well as interest rates on housing loans also contributed towards lowering excess demand, especially from second time home loanees. The Indian banks having branches abroad were also not much affected as their exposure to mortgage backed securities had been quite low. Ultimately, fund flows to the Indian stock market will improve as the fundamentals of the Indian corporate sector continue to be good. Meanwhile, the fall in the stock markets had the side-effect of weakening the (appreciating) rupee to over Rs 41 levels against the US$, and this would be welcomed by the Indian IT majors and other exporters like the textiles sector, as their dollar-denominated pay cheques will now fetch them a higher revenue.