Early 2000 : House prices started spiraling upwards in US and continued through early 2006
High house prices, hence to increase people’s buying power, housing interest and lending rates started decreasing – it increased demand for supply of new houses.
So, now banks started offering mortgage loan to people at these lower interest rates.
Interestingly, they also offered loan to people with poor or no credit histories – in return they asked them for higher interest charges.
First, what is a Mortgage Loan – a loan secured by giving a security/collateral to the bank. Now these borrowers offered the real estate as mortgage – i.e. their house – Now this is called “Sub-Prime Mortgages”
2004 – Federal Bank began a cycle of interest rates hikes that raised the cost of borrowing i.e. the interest rates offered by the bank for loan.
2005 – US housing market rates began tumbling.
2006 – Interest rates increased 16 times!!
Now, with increased interest rates and bad credit history, how will the borrowers pay back? Thus, several “sub-prime mortgage” holders started defaulting on their loans.
Moreover, the US housing market rates also tumbled. Thus, even if the banks sell the property, they won’t get their entire money back, as the market price of property has reduced.
Thus, this caused the business failure of many lenders. Now this is where the lenders report loses.
But, the lenders don’t stop at giving loans to people. These lenders are facing a high credit risk – i.e. the risk of borrower defaulting. In that case, the lender loses its money. So, lenders want to reduce its risk. So how does one reduce the risk – by selling the risk to someone else.
Now 2 questions – What does selling the risk means and why will someone buy the risk?
Lets deviate for a while and try to understand what is accident insurance. I have a ‘risk’ that I will have an accident anytime, so I insure myself. By making some payments to the insurance company regularly, I am assured when I have an accident, then insurance company will pay me money required to cover the ‘risk’ of accident. But where does insurance company makes money – because it gives insurance cover to those people who they think have a bleak chance of meeting an accident. Thus, if out of 10 people 5 people meet with accident, Insurance company makes profit by investing in the remaining 5.
Now lets try to put the thing in the loan offered by the banks to these borrowers. Bank had the ‘risk’ that these borrowers might default so it sold a part of its risks. How? By selling them to investment banks. Now, whatever interest borrowers paid to bank , the bank paid a part of the interest to the IB in return that if the borrowers fail to pay, then the IB will pay the entire amount due to the bank.
Now, interestingly, all borrowers failed to pay. So banks asked IB to compensate them. Thus with no safety net, IB had to incur huge losses because they paid to the bank the property price which has tumbled now.
The IB even tried to write off the losses but the amount of borrowing done was so huge that it could not compensate for the losses incurred by the bank!!!
High house prices, hence to increase people’s buying power, housing interest and lending rates started decreasing – it increased demand for supply of new houses.
So, now banks started offering mortgage loan to people at these lower interest rates.
Interestingly, they also offered loan to people with poor or no credit histories – in return they asked them for higher interest charges.
First, what is a Mortgage Loan – a loan secured by giving a security/collateral to the bank. Now these borrowers offered the real estate as mortgage – i.e. their house – Now this is called “Sub-Prime Mortgages”
2004 – Federal Bank began a cycle of interest rates hikes that raised the cost of borrowing i.e. the interest rates offered by the bank for loan.
2005 – US housing market rates began tumbling.
2006 – Interest rates increased 16 times!!
Now, with increased interest rates and bad credit history, how will the borrowers pay back? Thus, several “sub-prime mortgage” holders started defaulting on their loans.
Moreover, the US housing market rates also tumbled. Thus, even if the banks sell the property, they won’t get their entire money back, as the market price of property has reduced.
Thus, this caused the business failure of many lenders. Now this is where the lenders report loses.
But, the lenders don’t stop at giving loans to people. These lenders are facing a high credit risk – i.e. the risk of borrower defaulting. In that case, the lender loses its money. So, lenders want to reduce its risk. So how does one reduce the risk – by selling the risk to someone else.
Now 2 questions – What does selling the risk means and why will someone buy the risk?
Lets deviate for a while and try to understand what is accident insurance. I have a ‘risk’ that I will have an accident anytime, so I insure myself. By making some payments to the insurance company regularly, I am assured when I have an accident, then insurance company will pay me money required to cover the ‘risk’ of accident. But where does insurance company makes money – because it gives insurance cover to those people who they think have a bleak chance of meeting an accident. Thus, if out of 10 people 5 people meet with accident, Insurance company makes profit by investing in the remaining 5.
Now lets try to put the thing in the loan offered by the banks to these borrowers. Bank had the ‘risk’ that these borrowers might default so it sold a part of its risks. How? By selling them to investment banks. Now, whatever interest borrowers paid to bank , the bank paid a part of the interest to the IB in return that if the borrowers fail to pay, then the IB will pay the entire amount due to the bank.
Now, interestingly, all borrowers failed to pay. So banks asked IB to compensate them. Thus with no safety net, IB had to incur huge losses because they paid to the bank the property price which has tumbled now.
The IB even tried to write off the losses but the amount of borrowing done was so huge that it could not compensate for the losses incurred by the bank!!!
