sub prime what?

After the recent mortgage episode now all eyes are on America and Fed (Federal Reserve the central banking system in the Unites States like the RBI in India) and how are they going to wade across this mess.

Most economists say the genesis of the current crisis was some where near 1990.When all the Asian countries started joining the world economy leading to what in known as liberalization and globalization. But it was in the year 2000 when the dot-com bubble crashed it became quite clear that another crisis was imminent. Any big stock market bubble crash will lead to bankruptcy of some companies and investors in the market. This in turn leads to an economic recession.

In an effort to get out of the recession The Fed led by Alan Greenspan used the weapon famously known as “the Greenspan put” which is a way of ensuring liquidity in capital markets by lowering interest rates if necessary. Lowering the interest rates and relaxing the lending standards makes it is easy for people to borrow and companies to invest more and more in new projects (in this case avoiding a recession).

In 2003 the interest rates in US went as low as 1%. Every one started borrowing as the interest to be paid on them is almost negligible. Now, when there is so much liquidity in the market people want to invest somewhere and after the dot com crash no one was willing to look at stock options. So, other investment like real estate is where all the liquidity started flowing into. All of you know that more demand on a good will increase the price of it and so cost of house properties started insanely shooting up. Now that real estate properties are defying the laws of gravity and just going up and up, banks started give housing loans to everyone. After all if a person with bad credit history (mostly poor and other low income people) defaults there is always the house which can be sold at a very high price. And the banks can charge more interest rate to some one with a bad credit record because no one else was willing to give them that money. But these rates were just marginally high compared to others because the banks thought the risk involved in mortgage loans was very low, since the real estate prices have always been going up.

Now, this started spreading like an epidemic, every one is willing to buy a house. There was so much money involved in this market and the investment banks started jumping in too. They provided all the necessary money to the small banks and the small banks with their excellent network especially in rural areas and which can reach ordinary man quite easily provided all the necessary mortgage loans. Simply, now every one can buy a house. It’s not about every one owning a house, it’s about cashing out in this boom.

The interest cannot be so low always, lower interest rates have their own consequences if they go beyond a limit. Lower the interest rates higher the liquidity in the market, more the liquidity; more the liquidity i.e. more the money and the supply not matching up will lead to inflation. So The Fed got panicky because of incipient inflation and started raising the interest rates. The interest rates went as high as 6% within no time. From 1% to 6%, it is easy imagine the raise in the interest one has to pay on a loan. Plus every one entered the housing market and it reached a saturation limit. So people suddenly realize they cannot pay the interest on loans any more and they try selling their houses (which now every one is doing, so again do the demand supply thingy; more sellers less buyers) the price plunge down. The smart investment banks coerced the small banks for their money; small banks foreclosed all the defaulted loans only to realize that the houses are not that worthy any more. Every one was just trying to sell their houses. And so, we have a crisis. Every one is in a loss now. Banks decide to stop lending because of the existing uncertainty, not just mortgage debt but other forms of debt as well. This led to the credit crunch which most of us would have heard of recently. When investment banks are in loss and interest rates are high, story is back to square one, stock market crashes.

The sub prime market was worth in trillions; the losses involved are still being estimated.

Fed wakes up, Greenspan put, exactly what is happening right now, Fed has decreased the discount rates and is expected to decrease even more. Most importantly elections coming, the Republicans and the Democratic party, everyone starts thinking on how to rescue the affected leading to more pressure on The Fed. Because of which, now the markets are recovering but all these efforts to rescue will just lead to a postponement of this crisis some time soon but definitely not before the elections of course.

A dot-com bubble bursts, interest rates go down leading to housing market bubble burst.

If The Fed opts to cut down the interest rates again what is going to be the next bubble to burst?