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Thursday, September 25, 2008

Sub- Prime & Mortgage bonds: What went wrong with these Innovative Instruments ??

Bear sterns, Morgan Stanley, Lehman Brothers &  AIG just being saved from going bankrupt.

Why is it so and why there is so much news about Sub Prime crisis for couple of months now.

Well to start with I decided to understand from the very basic of what is causing trouble to America & World’s financial sector.


Sub prime crisis is related to home loan default. Well to start with, let’s see how a person got a loan in America previously. As you can see from the diagram below, the Bank after doing Home & income check used to assign loan to borrower. The borrower used to repay in installments. The banks used to finance other lending through repayments & deposits they got from borrowers.


Now the problem with this model was that Loans were given to people who had relatively good credit record and strong documentation of Income. The other thing was that the banks were also not able to provide loans to new borrowers as they used deposits from its existing customers to give fresh loans.


So we had two problems

- Loan given to people with strong creditworthiness

- Limited amount to finance new loans


In-order to address these issues some concepts were introduced:

1. Sub- prime loans

2. Mortgage Bond


Sub prime lending: It refers to lending to borrowers with not too strong credit histories and documentation of Income. These were the borrowers who were shunned away from Prime lenders like government sponsored Freddie Mac.


Mortgage Bonds: Now mortgage bonds were used as an instrument to raise money from bond market which was used by banks to finance loans to new borrowers.


 So what do we have here

 1st,  the problem of giving loans to only selected borrowers (those with good creditworthiness) was dealt by sub prime lending. This opened up a whole new market and brought in new customer group (those with relatively low creditworthiness- People at Bottom of pyramid if we can say).

  2nd, Now In order to fund loans for these new borrowers,  the mortgage bonds were used.  

 It seems that the banking industry had innovated with these instruments and added new customers to its portfolio. 

 The wave of sub prime loans was so high that for many years cities like Cleveland was termed as Sub prime capital of America. By 2005 one in five mortgages were sub-prime. As a result housing prices across America increased rapidly.




The problem was increase in interest rates to be paid by borrowers on their loans taken.

According to the rule the new sub prime mortgages were fixed for 2 years and after that would become higher & dependent according to FED reserve rates.


The FED increased the interest rates(around 17 times) which raised the cost. As a result people were not able to pay which led to increase in foreclosures. There was a wave of repossessions by Banks acting on behalf of bond holders. This resulted in huge supply of houses due to which the housing prices dropped significantly.

As a result the related industries like White goods, Construction, etc saw a drop in demand. Overall which resulted in economy going into recession.


Now the Big question here is that no doubt Sub prime and mortgage bonds were innovative instruments which were successful in providing people who didn't had strong creditworthiness and stable income for a house, but is it because ecosystem in which they existed were not supporting them properly, led these innovative instruments of growth and prosperity  turn into instruments of destruction ??

 SO in short Is it that Innovation cannot happen as a standalone thing rather the ecosystem in which it happens should support it. 

You decide !!


Neeraj with Inputs from Rohan S.

(Image Source: BBC news,