The cause and effect of US sub-prime crisis

Before discussing the effects of US sub-prime crisis on Asian and European capital markets, we have to understand what is US sub-prime market? How it has affected other markets.

What is US sub-prime market?

In short, sub-prime (lending market) refers to the home loan market catering to the persons whose credit rating is low due to which they will not get a regular loan at prime lending rate as announced by US Federal Bank. The sub-prime rates are much higher than prime lending rates. Presently for a 30 year loan, prime lending rate is in the range of 4 to 51/2 percent and sub-prime interest rates are higher by 200 to 300 basis points over the prime lending rate as the risk is more for the borrower. The lower the credit score and the smaller the down-payment, the higher are the interest rates. However, the entire structure of rates and fees is higher at sub-prime lenders to cover the greater risk and higher costs of sub-prime lending. By its nature, a higher percentage of sub-prime than of prime loans go into default. Sub-prime lending costs are also higher because more applications are rejected and marketing costs are higher.

A sub-prime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders. The interest rate they charge are are uniformly higher than those quoted by mainstream lenders. A subprime borrower is one who cannot qualify for prime financing terms but can qualify for subprime financing terms. The failure to qualify for prime financing is due primarily to low credit scores. In US, every borrower is given credit rating depending on his income levels, past payment history etc. A very low score will disqualify for a softer loan. Some other factors can also influence the decision of the financier, including purpose of loan and property type.

The development of the sub-prime market has made mortgages (and home ownership) available to a segment of the population that otherwise would have been shut out of the market. That’s the good news.

Why sub-prime market is in the news?

In US housing prices have been moving up from the year 2000 onwards till the end of 2005. American housing prices have not seen a similar pace of growth since 1979. During this period, all the borrowers went aggessively into the sub-prime lending market. But, during this period, the US Federal Bank either raised or kept constant the interest rates and most of sub-prime lending is based on floating interest rate mechanism. With the raising interest rates, the repayment amount by the sub-prime lenders has gone up. Coupled with this is the slump in home prices from the end of 2005 to the end of 2006 which was the biggest year over year drop. The banks and mortgage lenders are scrambling for creative ways to keep people in their homes but the subprime market is already teetering and foreclosures are on the rise. With the rising interest burden, subprime lenders have lately suffered widespread mortgage defaults in the United States, sparking fears the trend will dampen consumer spending and overall US growth. It is estimated that there are a potential $100bn (£50bn) worth of sub-prime mortgage defaults, from less than credit-worthy borrowers, mainly in the US.

Why investors in Asian and European markets fear sub-prime crisis in US?

1. Investor Worries

Investors are worried about a global credit crunch as more banks and investment funds around the world reveal their exposure to the slumping US subprime, or high-risk, home loan sector, analysts said. The fear is that banks will suspend normal lending practices as they move to cover their losses, thereby restricting access to credit for investors and companies. Central banks across the world have since last week pumped tens of billions of dollars into the banking system, offering loans at lower rates to commercial banks to forestall a credit crunch that could damage economic growth.

Reportedly, the interest rates are lowest in Japan with cheaper yen loans. Global financial players, who had borrowed in low-interest yen to invest elsewhere, dumped stocks on fear of rise of the yen and reports of trouble in the biggest US mortgage lender, Countrywide Financial Corp. While Countrywide took an $ 11.5 billion emergency loan, the US Federal Reserve stepped in to pump in $5 billion to prevent liquidity crunch. In fact, US central bank has infused $76 billion into troubled banks till thursday .

2. Hedge Funds

Many say that the main culprits in this crisis are hedge funds and not the banks. Hedge funds typically borrow money to invest (and they've often borrowed shares and other securities too). But terms and conditions apply to their loans: lenders tell the hedge funds the debt must not rise above a specified proportion of the total fund. It would be like your bank telling you that your mortgage can't rise above 90% of the value of your house. Now what would happen if the value of your house fell? You would have to find some cash to repay some of the mortgage to ensure it was still not above 90% of the new lower value. The losses they've endured on some investments trigger the need to repay cash to prevent their loans breaching their terms. One way for hedge funds to find cash is to sell shares. Note that this does not mean the hedge funds are insolvent - they just need cash, and the easiest way to find it is to sell shares, pushing down the prices. This potentially could make the market getting into a vicious circle of falling prices, cash requirements and more falling prices.

3. Lending dries up

All kinds of bank lending have been affected by the failure of the sub-prime market. This is because the whole market in second-hand debt has been paralysed by the sub-prime problems. This affects the banks, who are sitting on debt they'd like to sell on, but can't. And it affects corporate borrowers, particularly the kind of borrowers who have been using debt to finance highly-leveraged takeovers. Those takeovers have helped prop up the stock market, and if they now evaporate, the stock market will probably fall.

4. The real economy

Finally, the tightening of credit conditions in the US housing market and beyond may have real economic effects that depress corporate profits. The pace of takeovers using borrowed money may slow down a bit. The world has been very dependent on US consumer spending. If that diminishes as the housing market and stock markets dive, then companies are in a pickle, the world over.

Indian and Global market scenario

Amid a crisis of confidence, the 30-share Sensex plunged 642.70 points (more than 4%) - the largest single-day fall in over four months - to close at 14,358.21 on Thursday. The 50-share Nifty tubmled 191.60 points to finish at 4,178.60. Key Asian markets were awash with red - the South Korean, Taiwanese and Indonesian indices closed around 5-7% lower. Australian home loan group RAMS said it had failed to roll over $5 bn in debt due to the US credit crunch, sending Sydney stocks down 5%. Seoul, which was closed on Wednesday, plunged 6.35%.

According to the provisional data, FIIs have net sold around Rs. 3,100 crore on Thursday in Indian bourses. Hedge funds are now being made out to be the root cause of this mayhem in the markets. Dealers said, as quoted in the Economic Times, the 5-10% decline in frontline stocks like Reliance and Tata Steel indicated distress sales by hedge funds that are facing problems in other markets. As quoted by ET, a Moragn Stanley strategy note isuued to the clients said market participants " do not fully appreciate that India is excessively reliant on external sources of risk capital and that these suppliers of risk capital tend to be indiscriminate in their behaviour in times of turbulence".

In this entire turmoil, who gets benefited? the exporters. When the demand for dollar raises by way of sale proceeds of stocks to be taken out from India by FIIs and Hedge Funds in dollars, the Rupee will depreciate against US dollar. In fact, the rupee dipped on Thursday by 1.5% to 41.36 level per dollar. When the inflows surges, rupee appreciates and when outflows surge, rupee depreciates.

Related Articles:-

• US housing sector - a bubble? - The Hindu - February 04, 2002
• US Housing Sector is Crashing, False Housing and Jobs statistics to eventually benefit Gold - The Market Oracle - February 23, 2007
• US housing difficulties cause for concern but no systemic threat: Moody's - breitbart.com - July 24, 2007
• Sub-prime crisis hits world markets - presstv.ir - August 16, 2007
• Sub-prime crisis 'won't hit growth' - Gulf Daily News - August 17, 2007
• What's behind the market turmoil - BBC News - August 17, 2007
• Hedge funds threatened in world turmoil - telegraph UK - August 17, 2007