Real Estate Investment (Part 2/3): Sub-Prime Crisis

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Sub-prime Crisis (2008) led to a severe global economic downturn with America as its epicenter. At the crux of the 2008 crisis was shattering of the myth that ‘housing prices have never fallen and never will’. Since 2000 the housing prices in America had risen continuously, it reached an all-time high and more than doubled any previous high in house prices.

American Banks in early 2000s introduced Subprime mortgaging as different from the Conventional lending and mortgaging. Sub-prime mortgaging refers to the lending to persons with poor credit rating, consequently with interest rates higher than usual. This opened up an avenue for an average American to reach for his American Dream and live in his own house. Sub-prime lending reached its peak between 2006 and 2008 and banks were lending to the unemployed, persons with no income or assets etc…

Predatory Banking practices by the banks while issuing subprime loans were central to the crisis. With a view that in the unlikely scenario of repayment, they would profit from the higher interest rate and should the borrower fail, (which they knew would happen), they would foreclose the land and profit because ‘housing prices cannot fall’.

Further to cope with their own risk, they repackaged these loans as securities and formed pools for investors and financial institutions from all over the world to invest. This was made easier by the popular myth of the time. These instruments were called Mortgage-backed securities (MBS) and played a significant role in reducing the responsibility felt by the bankers of conducting a credit check on the borrowers. Banks were lending to everyone without screening on their capacity to repay. Defaults were foreseeable.

Collateralized Debt Obligations (CDOs) became popular at this time. It refers to a financial instrument which pays investors out of different revenue generating resources. These instruments had various tranches with each representing risk adversity of its own. A peculiarity of CDO was that by combining debt instruments such as a mortgage with other securities, it was able to easily sell highly risky and practically garbage debt into AAA-rated securities. This, in turn, promoted more borrowing and more investing activities in the sector.

It is also believed that the lack of regulatory oversight in respect of shadow banking was catalytic to the market’s exposure to such a fall. Shadow banks are non-depository banks such as investment banks, Investment Vehicles, Hedge-funds, NBFCs etc. Since they do not receive traditional deposits, they are typically regulated more leniently. During this period, the unregulated Credit Default Swap (CDS) was also sighted.

CDS, as the name suggests involves the exchange of risk of default between two parties in consideration of periodic income payments. The issuer seeks protection by way of holding these bonds against the risk that borrower defaults if it does, the insurer compensates the bondholder. The American International Group Financial Products (AIGFP) insured these Credit Default Swaps with its inquiry that the chance of having to pay out insurances was next to impossible. However, with the foreclosures hitting all-time high in America, AIGFP was required to fuel out a huge chunk of money and got very close to bankruptcy when it was bailed out ($85 billion) by the U.S. Financial Stability Oversight Council (FSOC)

Lehman Brothers, a big league player (one of the biggest ones) in the global banking scenario had heavily invested in American mortgages utilizing leverage at a ratio of as high as 30:1. With the decline in prices of real estate, Lehman became vulnerable and attempted to fight off losses by various means, however in 2008, it had to undergo an emergency liquidation to avoid the doom of an even costlier government bailout after a meeting of the Federal Reserve and various major investment banks. Lehman Brother’s Bankruptcy triggered a massive selloff in the global markets, effects were felt from London to China and also India.

At the end of the day, homebuyers who had no money to repay to loans were left with three alternatives:

  • Await bank’s foreclosures
  • Renegotiate the lending agreement
  • Walk out as a defaulter and lose the house

 

Foreclosure rate was at a record high of 81% in late 2008 to 2009, thousands of people lost their houses, with the poorest being the worse hit. Banks were at a loss of words with the severe drop in house prices. Houses were being undervalued and sold at prices lesser than their value, many stayed unsold for long, while its residents were homeless. While the Government bailed out major financial institutions and players, the middle class and the poor were left to struggle.

The Sub-prime crisis gave several cues for the rest of the world to learn from the American regulation, mal-regulation nor the absence of any regulation in some spheres. The crisis has elaborated the need for thoughtful policy-making and the importance of the same.

– Manal Shah

On a Lighter note: The Crisis is wonderfully portrayed in movies such as The Big ShortInside Job (Movie).

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