kamalkali1962's picture
The recent tsunami what has devastated the economy of the United States and with it many other west European economies and finally more or less the global economy as whole. It started from the sub-prime crises. That relates to housing finance in US. In fact we all by now know that. But what is a sub-prime crisis! It is the loan offered at an interest rate which is lower that the prime lending rate, fixed by the central bank. In India, Reserve Bank of India, review and fix it in every quarter. So, when the loans offered at a sub-prime rate of interest went bad (not paid back), that created the crisis. But how come that happened, is bit difficult to understand for them who are only exposed to prudential banking norm as it is in India. We know when we approach for housing loan to any banks or housing loan finance companies, as a security they take the housing unit as a collateral or hypothecation for the same loan. In case the loan going bad, the housing unit is sold off, the money realized, is first taken for settlement of loan and balance if any, after meeting the entire expenses paid back to the borrower. In case the amount of realization falls short of the due amount, then mostly it is written off as bad debt. However, in prudential banking norm, the margin for housing loan is sufficient enough to realize the dues, if the action taken in time. But this all happen in a stable economic condition. As of now, in the US the housing market crashed, say the housing unit that used to cost $100000 a year ago , right now it is available at a hyper discounted price at about anything between $25000 to $40000 ! Even with the best prudential norm any banker who might have financed that house, in case of the credit going bad, they can’t recover their dues by selling them off. But it is not that simple, on the first place we have to find how the housing price skyrocketed in the past five or more years in US. Who were responsible for that? How the housing bubbles burst and damaged the entire world economy! The current crisis has raised several questions about the very success of market economy, globalization et al. The promulgators of free market economy who also favored the globalization always claimed that the market is matured enough to take care of itself. But on the contrary the socialistic measures have become so much necessary for rescuing the banking system by pumping exchequer’s funds into it. It is the measure required to restore confidence in the public mind in the age old banking system. The whole world is surprise to know that banker like Lehman Bros, or insurer like AIG were would have been bankrupt unless rescued by the Bush government. Let us get a close look into the matters for their becoming so. The troubles bred in the hatcheries of US and west European financial organizations undoubtedly. It is because of the paradigm changes they have gone in the past years. The age old banking system, what is now multi dimensional, has increased the trend of risky finances in many folds. Because; now the risk for finance, is distributed or can be sold to others. Who is ready to buy it for cheap and reap profits if everything goes well, if not, then these finances are insured for their risk of going bad. Now the insure companies are to compensate the losses. It may be cleared with brief description how the financial system in the US and Western world goes on. The conventional banking system use to offer a common platform to the depositors and borrowers, while playing the role of middlemen. Banks while accepting money from one; use to lend the same to another. In between they use to collect the interest from the borrower and a part which was paid to the depositor, the marginal amount was their profit. This is the way the stability of the banking system has been maintained. But the new system is a multi level one, so it is complicated too. For example, let us consider a group of people have taken loan form bank for purchasing houses. Those houses are kept as mortgage with the bank as securities. It the old system, the money thus lent use to come back in installments lasting for 20 to 25 years. In the new system bank does not wait so long. What it does, it bundles up these finances then sell them to a new breed of bankers called investment banks, keeping their margin as low as 3 to 4 percent. Thus they absolve themselves of any risks related to those finance by selling them off. Now the risks of these housing finances are shouldered by these investment bankers. Better know, the Lehman Bros, Fanny mea or Freddy mac , all were investment bankers. Who all went sought insolvency and triggered the global economical destabilization. In fact , these investment banks have three more tasks to delegate after purchasing the loans from commercial banks. First of all they engage other financial institutions like JPMorgan, to collect the loan installment and interest from the borrowers. Next they get the loans insured by insurance companies like AIG, by paying them regular premium, ensuring the recovery of loan amount with interest in case they are going bad. Finally, these mortgage housing loans are then sold to several investors like mutual funds, pension funds or commercial banks. As the system looks, it is apparently safe, the investors who finally invest in those finances, consider these investment most safe as they are insured by insurance giant like AIG. All the financial institutions tagged in the chain where investment is safe and profit is guaranteed. This very sense of security, called for uncalled for finances for reaping more and more profits. The banks started financing those who do not merit them. The inflow of fresh funds pushed up the housing prices artificially. That offered the fresh scope of taking loans by the same borrowers who earlier bought his house taking loan. When the same house’s price went up to considerable extent, fresh finance was sought against the same collateral. That way fresh funds infused in the system further pushed up the housing prices. But the bubble burst with the housing price’s down ward trend. Initially, when the borrowers failed to make the payment of their housing loans, then the insurance companies promptly made good to the investment banks. But with number of defaulters ever increasing, they went insolvent. Now, the onus of repayment to the investors fell on the investment bankers. Who started selling their securities, obviously they were housing units. In a falling market, any further sell would trigger the free fall of housing prices. So, not it is their turn to become bankrupt or insolvent. Since they go insolvent, they took along those who invested in their housing bonds. So the global crisis emerges as the participants in those investments were from all over the world. So, such crisis never rose before, it is quite different than great depression what took place in 1929-1930. Though; many economists and gurus are comparing the current crisis with “the great depression”. The free market economy, what has been the shining son of capitalist worlds, is put to questions about its sustainability.
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Karen's picture

Hi there, kamalkali.

Welcome to RevResponse. Can I ask what made you post this article?

Do you have any questions I can help you with?