Wednesday, October 8, 2008

What is Sub Prime Crisis?

What exactly is the sub prime crisis?

 

The word “prime” implies that which is optimum. “Sub prime” is that which is graded below optimum.

 

If Mr.Prime has a very good job, good savings and assets with better liquidity ( can be disposed off easily and profitably in a crisis situation)  then he is a prime candidate for obtaining loans from any bank.

 

Mr.Subprime , a carpenter by profession doesn’t have a regular income (no job), no assets worth showing off, not even good friends to stand guarantee is a sub prime candidate in the eyes of the banker.

 

What if Mr.Subprime goes to Mr.Local Bank  to buy a home for himself? It would seem that no banker worth his designer suit would touch him with a long pole. But, on the contrary some banks  gleefully welcome Mr.Subprime offering him attractive loans. What is the catch?

1.He will have to pay a higher interest rate.

2. In case he fails to repay the loan,  bank will assume ownership of the house he buys using the loan.

 

Not so bad . Looks like a win- win situation. 

 

So where and when did the situation turn into a global “lose – lose more” situation?

 

For the time being lets forget Mr.Subprime who is happy with his family in his newly bought home. We shift our attention  Mr.Local Banker who gave him the high priced loan.

 

Mr. Local Banker after seeing off Mr. Sub prime receives a few more customers and sanctions loans for some. By end of day he shuffles through his papers and realizes that he has made very good business and gives himself a pat at his back.

 

He collects all the loan documents, compiles them all in a file , puts a covering sheet on top and takes it to Mr. Big Banker, who is an  investment analyst in a well known bank in the neighbouring big  city.   

 

Mr.Big Banker, who already has got a collection of such files from different smaller banks welcomes Mr.Local banker with a smile. Lets listen to their conversation:

 

(after the customary greetings, the yget down to serious business..)

 

Small: All these guys have taken loans from me and have pledged their property against these loans.  Why don’t you take this file as  my collateral and loan me some BIG money, I badly need for circulation in my bank?

 

Big: Ok lemme have a look at it. My insurance company needs some sort of solid proof that I have enough cash flow with me. Ill pass on this file to them.

 

Mr.Big Banker then collects all those files from his huge wooden shelf , puts a covering note to it and bundles them off to his Insurance Company with a copy to his Head Office.

(hes sure to get a hefty bonus on account of this transaction!)

 

 

Mr.SubPrime, not knowing that his property deed has been bundled several times over along with a few million others enjoys his life in his newly bought house.

 

Not for long.

After some time, he finds it difficult to pay off his (euphemistically named ) Easy Monthly Installments. Meanwhile he notices the worried looks on several of his neighbour’s faces too!   Rumours get confirmed that some of the houses in nearby plots have already been taken over by the respective banks!

 

And what the hell does the Bank do with these taken-over homes? They cant keep it in their safe lockers! They sell it to prospective buyers. More and more houses are being sold by banks .. Gradually, in the beginning and later on suddenly property prices  falls from their actual values.

 

One fine morning Mr. Sub Prime realizes that the current value of the house he is occupying is just a fraction of the amount he has to pay back to the bank. He picks up the phone and tells Mr. Local Banker “ Hey you, I cant pay you back my loan amount. Do whatever you want to!” 

 

The next morning, Mr. SubPrime and family move out of their house , Mr. Local Bank posts a notice (printed in bulk!) announcing that the house is for sale! 

 

With more and more houses on sale, less and less of new buildings are being built. Carpenters like Mr. Sub Prime and so many other tradesmen find job opportunities getting scarcer. Lesser amount of building materials are being sold, lesser equipments are being bought, lesser income in house holds.

 

Supermarkets that once sold consumer goods like  hot cakes are busy chasing flies( with lesser employees- most have been fired already!)

 

Backtracking the goods chain, its revealed that factories receive fewer orders , transport requirements are on the downslide, orders for raw materials for product and equipments aren’t generated either. 

People (and institutions) short of cash turn to their savings and investments. Money is withdrawn from stock exchanges, amomh other investments. As shares go down, more people withdraw theirs from the market further driving down the stocks.Panic selling results in  Share prices tumble down. 


Hey ! hold on, where are the banks ? They should be having enough money to help them all out!

 

That’s the most “grimmest” situation of all.

 

Banks, small, big and medium have over the past few years loaned huge amounts of money for their clients to buy new homes. Their coffers are almost empty now but for the valueless property deeds and “House For Sale” boards hanging in front of the discarded homes! 

 

And while Mr.Sub Prime goes homeless, his property document which has made several rounds of  packaging and repackaging in all levels of banking structure (along with a few million others totaling multiples of trillions of dollars)  is now worth not more than a toilet paper!

 

There goes an economy down the drain!

 

 

10 comments:

prasoon said...

Good one ,gave me a clear picture of the banking structure.
keep it up,keep writing.

regards
prasoon

Gokuladas said...

good babu, simple & legible. i dont think this topic can be explained simpler than this.
thanx

Anonymous said...

The epilogue to the story:

Mr. Sub-prime along with his "exiled" neighbours go to Galvestone to claim any Ike related insurance relief and votes for Obama.

Mr and Mrs. Local banker are having their candle-light dinner with some rich Chinese in a Shanghai restaurant waiting for the Real Estate company owner who got the money selling the property first to Mr. Subprime through this bank. Together they have created a new "Emerging market Opportunities Fund" which is being sold to the hapless Chinese.

Mr. or (Ms.) Big Banker, who's just out of his/(her) job opens their latest balance sheet which has a left (liability) side and a right(assets) side, and finds that on the left side, there is nothing right and on the right side, there's nothing left!

Ram

Anonymous said...

thatz how things work huh,hmm ,loan and bank were to this moment for me just another four letter word,,,, biju syed

Joseph Mathews said...

Babu -

excellent one yaar....

In fact the story applies a great deal to my case.. I began to notice the sub prime crisis trickle in back in the early months of 2005. Since my wife and I had already decided to return to India in 2006, we were initially thinking of listing the house for sale by Dec of '05. .. But by the March there were rumblings of excess supply of houses ( even though the demand did not relatively come down ) - This specifically refers to houses in the Greater Sacramento area where multi farious builers even from The east coast came over and set up shop since the early 2000's , since land was cheap and plenty - they did what was being done in Kochi ( under the name of smart city).
Well.. to continue with my episode - we quickly moved to an apartment and got the formalities of house inspection, pest, flood control reports etc.. all jargon which was considered peremptory as part of a house sale process ( mind you , Sacramento is not even a flood zone area,... but its all part of the game for Mr. Local and Big bankers to make even bigger money )..

Finally got the house sold after around 3 months.. though not at a loss ( considering capital gains and sweat equity ) ..
But listten to this.. I recently went on a website ( its called www.zillow.com) which would give the current house prices and sales data all pretty accurate since the house was built. You could just punch in your house address, zip code etc... and guess my house which was purchased in 2005 November was purchased ( or should I say acquired thru a foreclosure deal ?) at a price nearly 200,000 dollars less than my sale price and was relisted back for sale thru Prudential realtors for a price 17,000 US$ more than the foreclosed price...
Now poor Mr. Sub Prime ( who bought my house in 2005) must be wallowing in debt and an overworked plastic card ( the credit card per se) .. but hey .. does the US $700 billion "bail out" really help such naive consumers who lap up on low floating rates of interest called Adjustable rates of mortgages ( ARM for short)...
I surmise its rightly called so... since not only does it take off your arm paying up for it.. but a great deal of your leg and pretty much your head ! !

So long

JAM

shyam said...

nicely explained in simple words..
good job

cheers,
shyam

Amjad said...

Hi Babu,

You put it in a nice way . How the world is going to get through ? It is no magic to forcast it , I know . Still it is funny to see the right wing keeping mum on the issue ,biting their nails (world over).

But who to blame here Babu ? Who you would point your finger at ,given a chance to do so ?

Keep your good works !


Amjad

MADAN said...

Babu,

Described the things in simple words. I felt like attending my primary classes. It was very much informative and you presented it in a nice way.

Regards,
Madan

Unni said...

Came to know about this blog from a friend of mine and found it really interesting.

Please have a look at

www.pragoti.org

for a comprehensive coverage on the same.

Few links in this regard are


Let's learn from the US financial disaster

http://www.pragoti.org/node/2183

Can the Financial Crisis Be Reversed? — Interview of John Bellamy Foster

http://www.pragoti.org/node/2217

The People's Republic of Wall Street -- A Real News Network video

http://www.pragoti.org/node/2179

Financial Crisis in the US: Lessons for Indian Policymakers

http://www.pragoti.org/node/2173

Thanks again for the article




Unni.P.S

Nikhil said...

Hi Babu,

Well explained in simple language,
I had couple of Q's??

1. Who is the big banker & where does the big banker get his big money from ?
2. What happens after the insurance company receives the files?
3.If the coffers of banks are empty where is all the money getting accumulated??

Nikhil