Subprime Crisis

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Apurva Dhamankar

11/22/20223 min read

Nobody will ever forget the terrifying 2008 recession. But this crisis did not occur overnight; consider how poor investment decisions can have a multiplier effect, threatening the entire economy.

Investors withdrew their money from the stock market after the dot-com bubble broke between 2000 and 2002. because IT firms were no longer providing profits. On the other hand, in order to stimulate economic growth, US banks offered low interest rates on deposits. US authorities were experimenting with various strategies to enhance the market's money supply. Banks in the United States were encouraging individuals to take out house loans with cheaper interest rates. Lower borrowing rates spurred demand for homes, causing real estate values in the United States to skyrocket. Investors looking for a decent investment opportunity opted to speculate on real estate.

Now, the investment banks enter the scenario. Investment banks act as intermediaries for firms in IPOs, mergers and acquisitions, and derivative transactions. Investment banks would buy a large number of house loans from traditional banks. They then devised a sophisticated derivative product called "collateralized debt obligations" by merging these loans. Even rating firms awarded these CDOs the highest grade, AAA. These CDOs would now be sold to investors by investment banks.

Because demand for these CDOs was so high, investment banks urged regular banks to make more loans. However, at this time, banks had previously made loans to people with excellent credit. As a result, in order to make more loans, banks began to provide low-quality loans known as "subprime loans," also known as NINJA loans (no income, no job, and no assets for banking). Even CDOs based on subprime loans obtained AAA ratings and, consequently, considerable investor demand. Only two banks, Countrywide Financial Corporation and Ameriquest Mortgage Company, made subprime loans totaling $ 177 billion. Many investment banks and individuals made billions of dollars selling CDOs between 2000 and 2007. Even rating agencies made great profits during this time period, with Moody's profit increasing fourfold. AIG, the world's largest insurance business, began insuring CDOs, also known as credit default swaps. It's worth noting that even people who didn't buy the CDOs might take CDS against them. AIG employees were encouraged to sell CDS.

However, this beautiful picture began to fade in 2007. because banks have made loans at variable interest rates. The majority of the borrowers were unaware of this pricing arrangement. When interest rates began to rise, many subprime borrowers began to fall behind on their payments. The banks then began to sell the assets in order to recover their losses. The cascade impact now begins. As banks were unable to recover the debts, the value of CDOs began to decline. AIG was forced to cover the loss on CDOs and compensate investors. AIG alone had to suffer a $99 billion loss. To avert further disaster, the US government provided AIG with an $85 billion bailout. Fannie Mae and Freddie Mac got themselves into a lot of trouble because they encouraged lax lending standards.

No one was willing to invest in CDOs, and the top five investment banks in the United States were on the edge of failing. Lehman Brothers Holdings Inc. went insolvent, and around 25,000 of its employees were laid off. J.P. Morgan Chase purchased Bear Stearns, and Bank of America purchased Merrill Lynch. In total, banks and the US government lost roughly $450 billion. Obtaining bank loans became difficult during this period, and many sectors suffered as a result. This caused the whole US economy to slow down. The unemployment rate had skyrocketed.

As the ability of US banks to lend money decreased, banks began to raise interest rates. As a result of this, India saw significant capital outflows, causing the rupee to weaken. The RBI had extra money at the time, and the market's money supply was low. India entered a recession when aggregate demand fell. Because the United States is an economic superpower, its problems became worldwide, and the whole globe slid into an economic downturn.

Thank you.

Regards,

Bhairavi Bondale,

Kautilya, IBS Mumbai.

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