Monday, February 15, 2010

Understanding the sub-prime mortgage crisis in laymen terms

Understanding the sub-prime mortgage crisis in laymen terms

There are different kind of people who want mortgage in US. Those who are good people( who have the ability to pay back) are called prime borrowers. Similarly, those would are not good( those who may not be able to pay back) are called sub-prime. Now there is a guy called mortgage broker. You can assume someone from credit card industry - a credit card agent who is asking you to take a card- someone like that who is asking you to take a house on mortgage. Now, this mortgage broker knows the capacity of different people. He is issuing mortgage at small rates( 4-5%) to prime guys and on higher rate( 11-12%) to bad guys( sub-prime guys) He is doing this because he knows that they ll not be able to pay back, so he tells the bank that take higher interest from them and since they ll not pay back, we will do foreclosure of property and we( bank+broker) will get the house back and we ll make money also in this process. So, what happens is that due to his greed, mortgage broker gives huge loans to bad guys. Now there are so many houses which have been taken up by bad guys. mortgage-broker is happy due to his commisions and bank is also happy that it has put so many houses on mortgage.

So far, the story is good ! Now there is a twist in the story..

Now, here is what goes wrong. One by one, all bad guys start declaring bankruptcy. They are not able to pay back( since they never had the capacity to pay back) and so there are many foreclosures. So now, what we have is more number of houses chasing less num of takers !
By looking at this scenario, all the good guys say that why should we pay higher installments when the houses are so cheap and so they also start defaulting. Due to this, what happens is that banks are left with houses which no one wants to purchase !! And so the banks have no cash. only houses - which have depreciated a lot ! So banks become bankrupt and those who are not bankrupt, they need support from govt ! So the entire financial system has collapsed. And since the value of houses has become too less, the cost price has decreased tremendously- which means that growth is -ve OR there is recession in the economy.

All this, due to the greed of mortgage brokers and the bank officials who filled their pockets-without doing any chcks on people who will default !!!

PS: Dedicated to my friend, 'Ankit Sharma' who asked me to write a simple article on this topic. I hope I am able to give an overview of this financial mayhem in simple language