Monday, February 11, 2008

Subprime crisis: Worst may be yet to come

Much has been written on the subprime crisis and the impact it will have on the world, in general, and on India in particular. However, the worst might be yet to come.

So what is the subprime home loan market? It is aggregation of those individuals in the United States to whom, normal banks do not lend, for the simple reason that their credit histories are not good. Hence, there is a greater chance of the individual taking the loan defaulting. And no bank likes to take on customers who are likely to default.

Here is where institutions which have a good credit rating and are willing to take some amount of risk, come in. They borrow money from banks and lend it to the Americans who have a bad credit rating. They divide this loan, into a lot of small tranches and give it out as home loans to Americans who do not have a good credit rating and to whom the bank will not give a home loan directly.

They give out the loan at a rate of interest, which is obviously higher than the rate at which they had borrowed from the bank. This higher rate is referred to as the subprime rate and this home loan market is referred to as the subprime home loan market.

The loans given out in the subprime market are largely adjustable rate mortgages(ARMs). These mortgages are somewhat similar to the floating rate home loans given in India, where as the interest rates vary, the equated monthly installment (EMI) of the floating rate home loan also varies. But there is more to the ARMs than that.

The two most popular adjustable rate mortgages are the interest-only ARMs and payment-option ARMs.

Interest-only ARMs, as the name suggests, involves paying only the interest on the loan for the first few years. This can typically vary anywhere from 3 years to 10 years. After that the principal repayment kicks in. What this does is that during the initial few years of repaying the loan, it keeps the EMI low. Once the principal repayment kicks in, the EMI starts increasing substantially.

Under the payment-option ARM, the interest rate for the first year is very low. After that, the interest rate is the same as other mortgage loans. But the low interest rate comes with a cost attached. The unpaid interest, essentially the difference between the offered interest rate and the real interest rate that is being charged on other mortgages, gets added to the overall loan and the overall loan keeps increasing.

There are certain dates on which these loans are reset. When these loans are reset, the EMI on these loans changes. The largest resets are expected to happen in the first six months of next year.

In 2007, around $197 billion of subprime loans have been reset. Estimates suggest that in the first six months of 2008, around $521 billion of resets are expected. Of this resets nearly 30% will be on interest-only ARMs and payment-option ARMs.

What this means is that the EMI of the subprime borrowers, who have either an interest-option ARM or a payment-option ARM, is expected to go up, as and when these resets happen. Once this happens, whether the subprime borrowers will continue to pay their EMIs is not very certain.

As we have seen in the earlier articles, the institution giving out the home loans in the subprime market does not keep the loans on its books. It does not wait for the principal and the interest on the subprime home loans to be repaid. It goes ahead and securitises these loans. Securitisation essentially involves, 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.
The interest and the principal that is repaid by the subprime borrowers through EMI is passed onto these institutional investors who buy these financial securities.

Now once the EMIs go up, there is a great chance that subprime borrowers may not be able to pay them. If these EMIs are not paid, then investors who had bought the securitised paper will not get paid and hence suffer losses.

To cover their losses they may have to sell their investments in emerging markets like India, where there investments have been generating return.

And when they sell their investments in emerging markets, the markets are likely to fall, if there is less buying at that point of time.

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