2. PRIME LOANS AND SUBPRIME LOANS
• PRIME
Are the loans that are offered to borrowers with good credit
histories and carry lower rates of interests.
• SUBPRIME
Are the loans given to people with a bad credit rating who
are not eligible for prime loans. These are characterized by
high interest rates, poor quality collateral etc.
3. Why Subprime Loans?
• For banks to earn more money from the higher interest rates
• To let in the excluded such as the young, the people without a lot of
money in the bank to use for a down payment.
4. Main Players
• The Federal Reserve
• Investment banks
• Investors
• Homebuyers
• Rating Agencies
6. • In the early 2000’s, federal interest rate was reduced to 1% which made the
investors to invest in the Housing industry, which was certified as the best
investment by credit rating agencies.
• To earn more money, the lenders started giving mortgage loans
to subprime borrowers with the hope they can always get their
money even if the borrower defaults as the prices of houses
facing foreclosure are always rising.
• However, the borrowers defaulted on their mortgages rapidly
resulting in the increase of the supply of houses, for which
there is no enough demand.
• This led to decrease in the value of houses.
7. Effects of decrease in Housing prices
Housing Prices
Decreases
Negative
Equity(Home worth
less than mortgage)
Homeowners walk
away or Foreclosures
increase
Increased supply of
houses
Mortgage Payments
decline
Economic activity
slows down and
unemployment
increases
Value of MBS Decline
Banks restrict lending
Banks Incur
Losses
Bank capital
(loanable funds
decrease)
8. Effects of the Crisis
• Most of the losses were not incurred by homeowners but by the financial system.
• Large losses were incurred by the following groups:
I. Mortgage lenders: One third of top 30 mortgage lenders have either been
acquired or have filed for bankruptcy or have been liquidated.
II. Investment banks: Since the housing bubble burst, the five largest U.S.
investment banks have either filed for bankruptcy (Lehman Brothers), been
acquired by other Firms or become commercial banks subject to greater
Regulation.
III. Foreign investors (mainly banks and governments) who had invested in
mortgage backed securities.
IV. Insurance companies: (e.g., AIG) who had sold credit default swaps. Credit
default swaps are a type of contract that insures against the mortgage-backed
securities.
9. Effect on Indian Economy
• Exports dropped to $ 1.5 billion in November 2008, from $ 12.7 billion
a year ago.
• Manufacturing sectors like leather, textile, gems and jewellery have
been hit hard because of the slump in the demand.
• Tourism industry was also affected.
• IT sector was affected as majority of the firms derived 75% of income
from US.
