The sub-Prime mortgage crisis is considered to be the root cause for the financial meltdown in the U.S. Economy.
What Actually is Sub- Prime Mortgage Crisis?
The creditworthiness of the consumer is taken as a base to determine whether he falls in the Prime category or the subprime category.
Prime Category refers to people who have a good creditworthiness, They are offered loans at a lower rate of interest when compared to that of the Sub prime category. Sub Prime refers to people with not a good creditworthiness, They are charged a higher rate of interest when compared to that of the Prime Category.
The advantages to the banks when catering to a subprime category customer is that they charge a higher rate of interest due to the risk involved. The risk involved is the possibility of a delay in making the payments or possibility of non-repayment of the amount. In order to mitigate the risk they resort to mortgaging property.
The Housing Bubble- It started of in the Year 2002, when the property value started to increase rapidly and the demand for homes skyrocketed. People ended up making a business out of this phenomenon by mortgaging their property and buying a house, holding it for few days and then selling it to a prospective customer at a premium.
Evolution of C.D.O. - The federal government evolved the C.D.O.- Collateral Debt Obligation- A debt instrument which can be traded in the markets. Ex- X Co. lent a loan of say $2 Million repayable in 20 Years and if it feels that the customer is not likely to repay, it will sell the same to a financial institution for say $1.5 Million. The advantage for X Co. is that it gets back $1.5 Million immediately( Had it not traded CDO- It might or might not have got back the amount in a stipulated period say- 20 Yrs). The Advantage to the Finance Company is the $.5 Million(Difference between 2 Million and 1.5 Million) and the monthly interest is paid by the customer to the financial institution.
The problem started when the Housing Bubble reached its saturation point. A point at which almost everyone had an own house, from this point the prices started to take a downtrend, downtrend was very huge with almost 60-70 % fall in the prices of Houses. People who were mainly making a business of the boom in housing prices started to feel the pinch, Their repayment capacity along with the Value of the houses had gone for a toss forcing them to file for banktruptcy.
The Mortgage banks had to face with even more problems in the form of non payment of interest, non payment of Principal , Foreclosures and a steep decline in the prices of property had resulted in the potential of earning a very meagre amount out of the sale of a house.
Ex- Say A had pledged a House Property worth 1 Million and took a loan of say 800,000. In the event of repayment ,Bank disposes of the House property which was pledged earlier and due to the steep decline in house prices, Property which was worth a $Million might have fetched the bank only $200,000 thus resulting in a netloss of $600,000 and the interest which A had failed to pay which actually resulted in forcing the bank to dispose A's Asset.
Finally, One can Get a House in the U.S at a price of an Airticket!!!!!! Sounds strange but its true, The Housing bubble burst had hit the U.S. Homes such badly!
Moreover, The concept of C.D.O. had actually resulted in making huge profits few years back, but due to the down trend Many Mortgage banks which had resorted to sanctioning loans on a very large scale had to bear the brunt.
The Banks which were Struck by the Housing Bubble Burst turbulence are-
1.Bear Staines
2.Washington Mutual
3.Wachovia.
4.Fanni Mae.
5. Freddie Mac.
6. Lehmann Brothers.
7.Merill Lynch.
8. AIG - American International Group.
8. Citi Bank ( To a great extent- they managed to survive for this quarter).
Lehmann Brothers which was constantly present in the fortune 500 Companies looks like ended up in Misfortune 500 Companies:-)
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