"Subprime Crisis" for DUMMIES

Every AWAKE person walkin on US Streets must have heard, read, thought about "what is all the fuss about US Subprime crisis".
Based on my understanding of all the facts, research articles, numerous discussions with experts, i present here a layman's version of it.

What is Subprime?
Everything is US is available on credit so a person's credibility to repay those debts is all that matters. Company charge less to people who are more credible and more to ppl who r less credible. Credibility is established by FICO Credit Scores which get created everytime anyone in US touches upon credit.

Prime market are consumers with high credit scores. Companies happily offer these guys all kinds of credit
Subprime market consists of consumers with bad credit scores. These ppl have low income, purchasing power or have earlier defaulted or been laxed in paying back their credit. Traditionally, these people have little, if any, credit available to them. Noone gives loan to them.

So how far Subprime story goes?
All the way to 2000-01

What happened in 2000?
US economy & world were tryin hard to fight slowdown of 2000, where demand was low, consumer spending was low, less money was available in market and growth activities have slowed down. In order to push forward US Economy the then Chairman of US Fed Reserve, Greenspan lowered the fed fund rates, which in simple language means the rate at which financial instis offer loan. Since rates lowered, people starting running towards money, borrowed lots & lots of it to buy houses, build real estate get into growth activities. Economy started picking up. But Greenspan did a cardinal mistake, he reduced Fed fund rate by aprox 500bp i.e. 5 percentage points from 6.5% to 1.75% during 2001 & further to 1.25% in 2002.
Thr was too much demand for money & too much loans given out to house owners. Result, house prices went through the roof. Ppl could no longer afford houses, price were sky-high. But bonuses in fin instis (Banks) are based on how much loan can they give. So in order to keep distributing loans, banks devised various DISGUISED Glitzy products: No doc/low doc loans, interest only loans, PLAM loan, negatively amortizing loans and also went onto to offer loans to Subprime market.
These ppl have never given loans to subprime market and didnt know what rate to offer them (in short how to price loan), they shud charge more but how much more. So the second mistake Banks did was mispricing of loans. WHY?
Because loans are assets for banks, & banks go & sell off these assets in wallstreet like one sells his land to another buyer. They replenished their money & wallstreet held loans in their balance sheets. SO banks were not too much bothered about MISPRICING of loans.
But why did SMART, INTELLIGENT, SUAVE wallstreet firms buy it? Didnt they know it?
Wallstreet firms buy these loans based on thier RATINGS, create a pool of 1000s of them, cut them in pieces & sell them off to NOT SO SMART public. Sth like a construction firm buys bulk land, cut colonies & sells off indi pieces to individuals taking off its cut in between.
So imp part is RATING, which we will deal later.

Now what happened after this all. All these loans were constructed so tht ppl pay low monthly payments initially, & these payment balloon as time passes by. Somehow it convinced low credit score ppl, tht they can as well AFFORD a house. Then our favourite GREENSPAN committed another horrible mistake. He started incresing Fed fund rates all the way from low of 1% to 5.25% in 2006 (to curb inflation).
This increased monthly loan payments, combined with this payments on Interest ONLY loan etc started demanding principal payments by now. Payments ballooned & SUBPRIME borrowers cudnt keep up with payments, they defaulted on loan and asked banks to take away houses. House prices started dropping. Further, ppl saw tht loan is worth $1mn for a house which is now worth ONLY $500k. More ppl defaulted & further erosion of prices. Builders unable to sell existing houses. House invesntories build up & it all goes into vicious cycle.
But how it affects entire US Economy?
Residential real estate market is only 4% of US GDP (very small), but it is big driver of consumer spending which is 60-70% of US GDP. Every 10% fall in residential real estate, leads to contraction of $105 bn in consumer spending which takes of 25% out of growth of US GDP.

What happened in Financial Markets:
Now these i-banks which cut slices of pool of loans & sell them (Tranching of MBS), were sittin on huge inventories of these loans since they got them cheap, took huge amount of risk (what they best do) & thought they will sell it off all to NOT SO SMART public. But as people starting defaulting on loans (more than expected number), public started realising that banks have mispriced Subprime loans and are simply passing on the risk to them. Ppl stopped buying these inventories. Now this inventory started fallin in VALUE (makret value). Soon ibanks realized there unsold inventories have lost money & tht money was in order of billions of dollars. SMART bankers were not able to sell to NOT SO SMART public (which are instis, asset management companies etc etc).

Role of rating agencies:
Rating agencies rate the quality of bank loans which banks will pool, securitize and sell off in secondary markets. Based on these ratings of riskiness of loans, pricing of loans is done in secondary markets and if they r very risky, it will be inbuilt in its prices & entire Wallstreet will know this fact.
But tow problems here:
1) Rating agencies didnt have adequate models to rate these ALL NEW Subprime loans, so they force-fit old models on new data
2) Rating agencies are being selected and paid by the BANKS themselves. So in order to get business from Citibank, Moody's better rate its loans high
These agencies include Fitch, Moody's, S&P etc.
Now bad ratings, hid the actual risk inherent in these loans & ppl on Wallstreet bought them like crazy & why not, they though they will transfer risk down the line.

Who is at fault?
Lot of people
-Greenspan for reducing interest rates way too much down in 2001
-Banks for starting to offer LOANS which were mispriced since they have no experience of pricing subprime loans in diff economic cycles
-Subprime borrowers for believing tht they can afford otherwise an UNAFFORDABLE loan
-RATING Agencies for not mis-rating RISKY loans
-iBanks for not able to see through mispricing by lender banks & mis-rated securities by rating agencies
-Greenspan again for increasing interest rates back too high, and loosing entire investor confidence in credibility of US Fed & its monetary policies

Side-effects:
There is too much crisis in residential real estate market and Wallstreet has stopped replenishing the funds of lenders (Banks) to lend money to borrowers, since these people mispriced loans. Now in wake of unavailability of funds, liquidity crisis creeps in residential market. Now fears are tht even OTHER loans were also mispriced (loss of trust), so credit & liquidity crisis is seeping into other markets as well like commercial real estate, other mortgage industry. As told above, this is affects consumer spending and which in turn affects GDP. US Financial markets are integrated with world markets & hence slowdown here will have bad affect on Global Financial Markets.

What can be done?
Fed need to ease out fund rates i.e. reduce the interest rates to give some respite to borrowers and trigger economic growth. Fed has started doing tht but needs to further bring down rates
Second, from here on, DO NOT LET banks select rating agencies themselves & pay them. Instead a Govt body selects rating agency based on rotation basis & dues paid by companies to govt body which in turn pays the agency.
Third, let banks take the hit of mispricing & making bad decisions. Let them writedown loans, face wallstreet heat, share holders ire. But prevent them from closing down. If banks close down, money supply falls, interest rates sky-rocket and economy goes into recession. Work out compromise formulas to loan out these big commercial mortgage lenders.
Rest all, "Hail Capitalism !!!"

Disclaimer: There are lot of more pieces and other technical jargon which i have avoided to use in order to keep it simple.

- Amit (Jhalak) Garg

"Work as u gonna succeed, but plan on ur failures"