Subprime Lending Crisis and It's impact on the Emerging Markets

What is Credit Report?

credit report is, in many countries, a record of an individual's or a company's past borrowing and repaying, including information about late payments and bankruptcy. The term "credit reputation" can either be used synonymous to credit history or to credit score.

When a customer fills out an application for credit from a bank, store or credit card company, his or her information is forwarded to a credit bureau, along with constant updates on the status of his or her credit accounts, address, or any other changes made since the last time he or she applied for any credit.

This information is used by lenders such as credit card companies to determine an individual's or entity's credit worthiness; that is, determining an individual's or entity's means and willingness to repay an indebtedness. This helps determine whether to extend credit, and on what terms. With the adoption of risk-based pricing on almost all lending in the financial services industry, this report has become even more important since it is usually the sole element used to choose the annual percentage rate (APR).

What is subprime lending?

Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The term also refers to paper taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk.

Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.

Subprime lending is highly controversial. Opponents have alleged that the subprime lending companies engage in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. Proponents of the subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.

About Current Subprime Lending Crisis

The institution giving out the home loans in the subprime market does not stop here. It does not wait for the principal and the interest on the subprime home loans to be repaid, so that it can repay the loan it has taken from the bank.

It goes ahead and securitises these loans. Securitisation essentially involves, converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors. The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors who buy these financial securities.

The institution then takes the money that it gets from selling the financial securities and passes it on to the bank, it had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Well, not really.

This part we had already seen in the last article. The entire problem arose because institutions giving out subprime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution. Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan.

Given the fact that institutions giving out the loan do not take the risk, their incentive is in just giving out the loan. Whether the individual taking the home loan has the capacity to repay the loan, isn't their problem. Hence chances are that proper due diligence to give out the home loan is not done and loans are given out to individuals who are more likely to default.

Other than this, greater the amount of loan the institution gives out, greater is the amount it can securitise and, hence, greater the amount of money it can earn.

After borrowers started defaulting, it has come to light that institutions giving out loans in the subprime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans. As explained above, by giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and hence earn more money.

These loans were floating rate home loans, once interest rates started to go up the equated monthly installment (EMI) to repay these loans, went up as well. The borrowers who had bad credit ratings in the first place, could not service the higher EMIs and started defaulting.

Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in. Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money, does not have any inhibitions in lending out money again.

And so the story continues. Till, that is, one fine day when borrowers stop repaying. Investors who bought the financial securities cannot be serviced. So to make up their losses in the subprime market in the United States, they go out and sell their investments in emerging markets like India. Since the amount of selling in the market far outweighs the amount of buying, emerging markets like India have been falling.

-Various Sources