It took me a while to understand how the sub-prime loans and the credit crunch were related and how they were affecting the economy. I'm sure there are many who still do not understand what the credit crunch is all about. Let me try to explain:
- Banks have a "prime" rate, which is the lowest or best interest rate that is offered to people with a perfect credit rating.
- People with a less-than-perfect credit rating have to pay a premium on top of the prime interest rate.
- The premium is to compensate the lender for taking on the additional risk of loaning money to someone who may not be able to pay it back.
- Generally speaking, banks do not lend money to people with poor credit ratings.
- However, in the U.S., amidst the booming real estate market, many mortgages were sanctioned to Americans with poor credit ratings, on some seemingly good terms.
- Under the terms, the lenders charged a special interest rate which was below the prime rate (i.e. "sub-prime"), for the first three years.
- The catch was that after three years, the rate would reset to a rate significantly higher than the prime rate.
- The lenders, in the mean time, would immediately "sell" the mortgages, which are their assets (loan receivables), to investment companies.
- The investment companies, would "re-package" the mortgages into what are called "CDOs" or Collateralized Debt Obligations, which are in turn sold to investors all over the world. The investors were mainly big banks, brokerages and hedge funds in the U.S. and Europe.
- CDOs are nothing more than different types of loan receivables - e.g. credit card receivables, mortgage receivables (including sub-prime) etc.
- Ratings companies, like S&P and Moody's, gave a higher rating to the CDO than any individual receivable in it.
- The reasoning was that if one of the loan defaults, it still wouldn't affect the CDOs ability to pay interest - due to diversification of loans.
- The problems began when after three years, the interest rates reset to higher rates. Americans found it difficult to make their (now higher) monthly mortgage payments and faced foreclosures.
- With foreclosures numbering in the hundreds of thousands every month, investors began to question the value of their investment: the CDO.
- Ratings' agencies cut the rating on some mortgage-backed securities (like CDOs) from investment grade to pure junk status in one calendar year!
- This triggered massive panic among investors and the market for CDOs quickly dried up. Many panic-stricken investors sold these at a fraction of what it cost them to buy.
- Not knowing the true value of the CDOs they held, many investors who did not sell were forced (due to mark-to-market regulation) to take massive write-downs on the value of these investments. The write-downs have so far totalled almost half a trillion dollars and analysts expect the total to reach $1 trillion before it is all over.
- Now, "credit crunch" is when lenders are unwilling to lend money ("credit") to businesses. This happened because the lenders (banks) had lost billions in the CDO market and some no longer had the cash even to stay afloat, let alone lend money to others. If banks don't lend money, they don't make any money.
- The banks are even afraid to lend to each other because they don't know what the other bank's exposure to CDOs is, and their ability to pay back.
- If businesses are unable to borrow money (to expand or to pay their own obligations), then they either cut-back on expansion plans or may even go into bankruptcy, thus resulting in recessionary conditions.
- If individuals are unable to borrow, then they may have to declare bankruptcy or hold-off on buying big-ticket items like houses, automobiles and appliances, again, leading to recessionary conditions.
Quite interesting the way capital markets work!
