Sub-Prime Crisis

(Published in Banking Services Chronicle November 2008)

The sub-prime crisis in the US – a crisis created by risky debts turning bad – had already started making its presence felt in India from January. Markets went down as foreign institutional investors (FIIs) pulled out money from the capital market. But there was some light at the end of the tunnel. Today, with the collapse of Lehman Brothers and the ensuing financial turmoil across the world, the world seems to be groping in the dark.

How did all this happen? It is a clear case of greed overpowering discreetness among the financial engineers. Since banks in the US were flush with liquidity, they looked for avenues where the surplus could be employed. Real estate was a booming sector. So banks started offering loans to anyone and everyone without being too concerned about their credentials – a category that came to be known as “sub-prime borrowers”. Since the loans were considered riskier, a higher rate of interest was charged.

The story of greed might not have been so tragic if things had stopped ihere. In their pursuit of making more money, the mortgages of land and house were packaged as portfolios and sold further. Even the role of credit agencies like Moody’s and Standard & Poor is suspect in that they rated the derivatives thus obtained as not too risky. The game went further. There were Credit Default Swaps which hedged the risks of some but multiplied those of others.

Thus there was a chain of investment built on the same underlying assets, viz real estate. But excess of anything is bad. The real estate sector busted. And the sub-prime borrowers, in keeping with the rationale of their nomenclature, began to default on their loans. And the ball of financial performance was set rolling downward, much like the stone in the Sisyphean myth, but with far more negative consequences.

When the Titanics of the financial world start sinking, it is but natural that the mood across the world is sombre. Some believe that this is the worst phase for the world economy since the Great Depression of 1929.

Should we therefore mourn? Remember it is the darkest before dawn. The financial world will show resilience though it may take about a year for broad daylight to come back.