Global Subprime Meltdown!!:: Explained for Dummies!!!!

SUBPRIME MELTDOWN

Considering that this is prolly the hottest topic so far, I decided to make this very easy for people.

What is Subprime Lending?

All financial institutions while lending have a credit worthiness check on all borrowers. Eg in India, all banks refers to CIBIL as well as conduct other credit history checks like Pay slip cheque, tax returns etc, so as to find out the “riskiness quotient” of the borrower.

Similarly in US all banks have a FICO credit score (scale from 300 to 850) to define every individual. Subprime borrowers are typically individuals who have FICO score of less than 620. This is nothing more than an index to display the reduced repayment capacity of the borrowers.

Thus for
Borrowers: Its high interest rates for home loans
Lenders: High Risk , but then high gain!!

So big deal.. This happens all the time.. So what is the problem and what is it that is causing just global impacts on the equity market.
Well this is through a special instrument which is called the “CDO or the Collaterized Debt Obligation” which is nothing but a type of asset backed security and a structured credit product. In simple words Asset here is the Loan that the bank has given and thus a lot of them are grouped together and issued as security to the common people. Thus the banks reduse their total risk through using CDO as a funding vehicle for pertfolio investments in the credit risky fixed income assets!!
So this is how this comes on to the capital market. From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. In 2006, $200 billion in mezzanine ABS CDOs (mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds) were issued with an average exposure to subprime bonds of 70%.So we have people like Bear Sterns
So we know the theory about it.. Lets see how all of this started!!!

Well it starts from the very basic individual who is at the crux of it all.
He is the one who was given the loan , and that loan wa particularly the asset on which all the secirities were backed. So when theidicvidual defaults on the payments of his Home loan or mortage, then the loan goes bad, and when the loan goes bad, the aseets become non performing and finally you have no money to pay to the holders o the security.

One thing that I see here is that, the number of securities that people like Bear Stern isued on these assets were very very huge w/o taking into consideration the default risk.

So in 2006-07 when Fed started to increase rates, the interest rates started rising, people who had got easy home loans due to the real estate boom in US, were now under pressure to pay higher and huger interest. Thus people started defaulting on their mortgages.

Thus in early 2007, many subprime mortgage lenders filed for voluntary bankruptcy protection, ceased originating mortgage loans and/or ceased conducting business altogether.

So companies like Bear Stern were hit because their assets went bad and so their shares went down. Other big player also started going red and finally all the investors started going red. In India also ICICI is grappling to reduce the effect of the global meltdown as much as possible.

So that’s it guys!!!