what is US's subprime crisis?

The United States' subprime crisis has turned out to be bigger than previously thought and has the potential to drag the world's largest economy into a recession.

And although there are varying opinions on whether the US could slip into a recession or not, most economists do feel that despite the US Federal Reserve's rate cuts and the Bush administration's $161-billion economic aid plan, chances of a recession are high.

Be that as it may, one thing is for certain: the losses from the subprime that financial majors have incurred will take a long time to get over.

Given below, in the table, are the estimated losses that some of the world's largest banks have suffered on account of home loan defaults in the US. The total figure adds up to over $76 billion and does not take into account losses suffered by many other financial majors that had an exposure to the crisis.

Four Indian banks -- State Bank of India , ICICI Bank , Bank of Baroda, and Bank of India too have big exposure to credit derivatives, with the spreads on these widening since international lenders turned risk-averse following the crisis in the US subprime (or high-risk home loan) market.

Credit derivatives are instruments for which the underlying asset is a loan or a bond. Marking to market means valuing a portfolio based on the prevailing market price.

Subprime losses till date
Bank	Losses
Citigroup	$18.0 billion
UBS	$13.5 billion
Morgan Stanley	$9.4 billion
Merrill Lynch	$8.0 billion
HSBC	$3.4 billion
Bear Stearns	$3.2 billion
Deutsche Bank	$3.2 billion
Bank of America	$3.0 billion
Barclays	$2.6 billion
Royal Bank of Scotland	$2.6 billion
IKB	$2.6 billion
Societe Generale	$2.0 billion
Freddie Mac	$2.0 billion
Wachovia	$1.1 billion
Credit Suisse	$1.0 billion

ICICI Bank has the highest exposure of $1.5 billion. SBI has an estimated exposure of $1 billion, BoI of $300 million, and BoB of $150 million. About 5-10 per cent of this figure could be the losses that these banks could incur.

Understanding the subprime crisis

Just what is the subprime crisis? And why is it having such a decisive impact on the Indian stock market?

Let's understand it. Take, for example, an American who seeks a home loan, but does not have a very good credit rating. That essentially means that banks may not extend him a home loan. Enter, another American with stellar credit rating and the willingness to take on some risk. Given his good credit rating, banks are willing to give him a loan at a certain rate of interest.

This individual the divides the loan into small lots and gives them out as home loans to lots of Americans, who do not have very good credit rating and cannot get a home loan from any bank. He gives out the home loan at a rate of interest higher than it is paying to the bank it borrowed money from.

This higher rate is referred to as the subprime rate and this home loan market is referred to as the subprime home loan market.

By giving out a home loan to lots of individuals, the individual ensures that even if a few of them default, his overall position is not affected much. But the individual giving out loans in the subprime market does not stop here. He does not wait for the principal and the interest on the subprime home loans to be repaid, so that he can repay his loan to the bank, which has given him the loan.

He goes ahead and securitizes these loans. Securitization involves converting these home loans into financial securities, which promise to pay a certain rate of interest.

These financial securities are then sold to big institutional investors. The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors.

The individual giving out the subprime loans, takes the money that he gets from selling the financial securities and passes it on to the bank, he had taken the loan from, thereby repaying the loan.

A neat plan. But then things went horribly wrong. The subprime home loans were given out as floating rate home loans. So as interest rates increased, the rates on floating home loans too went up, and so did the monthly installments  needed to service these loans.

These high installments hit the subprime borrowers with the terrible force. Many, given their poor credit rating to begin with, defaulted. Once, more and more subprime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses.

So how did that effect stock markets in India? Institutional investors who had invested in securitized paper from the subprime home loan market, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world.

Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion. In order to invest more money in the US, money had to come in from somewhere. And this money came in from emerging markets like India, where their investments have been doing well.

These big institutional investors, to make good of their losses on the subprime market, have been selling their investments in India and other emerging markets. Since the amount of selling in the market far overweighs the amount of buying, Indian stock prices have been falling.