The sub-prime market emerged in the United States during the 1990's on account of a prolonged period of low interest rates during the Alan Greenspan regime. Many institutions offered home loans to borrowers who were unable to get the best rates from lenders, either due to their incomplete credit history or irregular payment record — creating what is now referred to as “sub-prime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy.Complex financial structures, which were the innovations of financial engineers, were used to separate interest risk from default risk by creating several trenches with differing levels of risk having commensurate returns on the same. The financial sector is one of the purest forms of a worldwide market; hence mortgages secured in the US got sold throughout the world as parts of more complicated financial instruments.
[...] Although, Wall Street analysts believe that the interest rates cut by the Fed will limit the damage from the financial distress[vi] currently faced in the US, the sub-prime mess can spread to other countries through the financial contagion. Sub-prime losses are mushrooming right from Canada to China. However, this time (as compared to the scenario during the East Asian Crisis, 1997) the emerging countries that are sitting on huge forex reserves and current account surpluses stand in a good position to withstand fleeting foreign investors. [...]
[...] that refers to the practice of making loans to borrowers who are unable to get the best rates from lenders, either due to their incomplete credit history or irregular payment record. Subprime loans have higher rates than equivalent prime loans; how much higher depends on factors such as credit score measure of past bill- paying regularity; also known as FICO score[i] in the US) of the borrower, size of down payment and delinquencies history in the recent past, debt service-to-income (DTI) ratio and, in some cases, the mortgage loan-to-value (LTV) ratio. [...]
[...] The ratings methodology for corporate credit risk is fundamentally different from that used for structured credit and yet the ratings that resulted were placed on the same scale, implying similar potential losses. To avoid future confusion, ratings for the different types of obligation should be clearly distinguished and investors should never just rely on ratings to determine investment policy. As the sub-prime bubble burst on August 15th the world witnessed the unfolding of the “Theory of Reflexivity”. The theory of reflexivity, which acts in sharp contrast to the Efficient Market Theory, states that any significant event/development can disrupt market equilibrium; markets become a victim of irrational exuberance. [...]
[...] Table Growth in late payments and foreclosures on Subprime Adjustable Rate Mortgages The loss of banks and mortgage companies is so difficult to gauge that despite infusion of $350bn by Central Banks from July to September 2007, the global liquidity crunch persists. The bankruptcies of banks and sub-prime lenders have accumulated global losses range anywhere from $750bn to trillion as on 30th September 2007[iv]. Why Study the Sub-Prime crisis? The sub-prime crisis is a good example to understand the contagion effect of a credit meltdown that has been witnessed since June 2007. [...]
[...] This root of the crisis was: excess dollar liquidity bubble created by the Fed between 2000-2007 (of US$ 7-8 trillion) after the bursting of the dot-com bubble and the terror-strike of 9/11/01; and the irresponsible profligacy of US macro-policy between 2000-2007 which has seen its twin fiscal and trade deficits spiral out of control[x]. Conclusion On the brighter side, one could say that the crisis affecting markets around the world means a healthier sharing of risks. However, the lesson from this crisis for Indian public is not to allow regulators and policy-makers to confuse regulatory failure with market failure. [...]
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