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On the Subprime Crisis

For quite some time I had been thinking to put up something on the topic. I am sure there wouldn’t be a person who hasn’t heard of the term by now. It has been a year since the buzz has been around. It has only *peaked* a couple of weeks ago with the collapse of the BIG financial giants. I’ve grown up hearing that United State’s economy being one of the most stable in the world only to find this sudden fiasco.

I tried to search for the term on Google and the definition itself spells doom!

  • Look at what Wikipedia has to offer for Sub Prime Lending. The term has created such confusions that Wikipedia still has issues with the article.
  • Investopedia says:

“A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment.”

To cut it short subprime lending is lending money to subprime borrowers (borrowers with a not-so-good credit history). To risk of default is accommodated through a higher than average interest rate.

That’s ok! But why did it result in such a big fiasco?

Well, fortunately I got an opportunity to get through a short course in financial instruments. I was amazed by the sheer complications of the various instruments floating in the markets! I guess the more complicacies one introduces, the higher is the respect in the financial community. Look at the following terms:

‘derivatives of derivatives’

‘reverse mortgage’

‘collateralized debt obligations’ (CODs)

Don’t they sound cool?

So tons of ultra-complicated financial instruments were made whose base was subprime loans. The complications grew so much, that no one could actually estimate the actual worth underlying these instruments. And when the borrowers started to default, everything started ripping apart like a castle of cards. Since the base of all the *exotic* instruments was these sub-prime debts, when the foundation collapsed, no one could have done anything to stop this.

What is money?

I never understand the fact that the Fractional Reserve Banking allows banks to print money by just keeping aside a meager percentage of deposits and lending out the rest. So the injection of currency is actually based on debts!!!!! The more indebted the citizens are, the more money gets injected into the country’s economy. Anyways, I am too naïve to comment further on this. There must be some rationale which I still have to understand. The following video is a MUST WATCH for anyone who wants to understand money:

Money as Debt

How is India impacted?

Fortunately, Indian bank’s exposure to such instruments is almost nil. So no direct concerns over there. However, with the US economy slowing down, some impact can’t be ruled out. I guess the whole world will have to slow down a bit. India seems to have definitely lost it’s shine as is evident through the Indian stock markets and general perception as well.

Why has everything to be so complicated? Why can’t things be simple? I guess the reason is human nature. We constantly look to challenge ourselves and in the process introduce complications. I hope things will settle down soon and people will be careful for a while. But I am sure all this will definitely manifest again in some or the other way in our own lifetimes!