Sub-Prime Crisis
According to Oxford dictionary, prime means the best quality. While sub means the substitute or lower in rank.
Sub-prime is a financial term that has been popularized currently due to the Wall Street credit crunch since 2007. This financial term “sub-prime” can be applied to “non-confirming” loan, those that do not meet the lender lending guideline and requirement, such as the size of mortgage amount, income to mortgage payment ratio, lack of creditworthiness or the quality of document provided with the loan. So basically, sub-prime borrowers are not affordable to pay that amount of the loan.
Beside the sub-prime loan policy, the FED fund rate is also one of the main causes of the world financial crisis today. During 2001 US is trying to boost their economic and reduce the FED fund rate from 6.5% (May 2000) to 1.0% (June 2003) and remain the 1.0% rate for 1 year till June 2004. At the same time, prime rate (loan rate) is moving with the same direction of the FED fund rate. Prime rate (loan rat) has reduced to 4% from 9% and remains the lowest prime rate (loan rate) for 1 year. This action will make the money out from the bank and involve in the economic activity. The GDP of United State in 4th quarter of 2001 is -1.3%. With the lower rate their GDP has increased to 8.0 in the 3rd quarter of 2003. More and more people are applying for the loan with the lowest rate.
Financial institutions don’t wish to take so much of risk on that amount of sub-prime loans. So they start to use CDO (collateralized debt obligation) to secure their risk. CDO is unregulated type of asset back security and structure credit product that pay series of coupon payment. By these CDO large financial institutions is allow to transfer debt off their account by pooling their debt with other financial institutions and then bringing these debts back on to them by calling it a Synthetic CDO asset. This also allows them to inflate their earning and hide their loss because they use the leveraging concept. The leverage ratio will be 20:1, 30:1 and even 40:1. For an example, the CDO with leverage ration 30:1 will make the value of the CDO toward 1 billion loan is worth 30 billion. That’s mean the 1 billion risk has been diversified into 30 billion worth CDO.
CDO normally traded about investment bank, commercial bank, hedge fund and some other financial institutions.
At the same time, CDO holder also worries about the risk their facing off and created CDS (credit default swap). CDS is the swap contract whereby the seller will pay the buyer series of payment and in exchange the buyer needs to pay off the credit instrument when it’s gone into default. This is similar with the insurance policy we have nowadays. Finally, issuance institutions have involved in the sub-prime crisis.
We are wondering how big the total market value of CDO and CDS in the world is. Many analysts said CDO and CDS is the main cause of the whole world financial crisis nowadays instead of the sub-prime along. The total value of the CDO and CDS is $565.3 billion USD and 62.2 trillion USD. That’s why when the underlying instruments default will bring up the disaster of hundreds trillion USD. Furthermore, these CDO and CDS are unregulated and not under any control of authority. Rating agency will determine whether the CDO is worth to buy with their rating. But it have no clear and well ethnic method to rate CDO. On the other hand, the pricing of the CDO and the payment of CDS is being done between buyers and sellers. There is no open market for these two financial instruments to be traded.
They are living comfortable wit those CDO and CDS because the housing price is increasing. There was a bull market in the real property market in 2003 and many of the CDO and CDS underlying instrument is mortgage loan. Any borrower can pay off their mortgage by selling off their property at higher price. In this condition, borrower may gain extra profit on this deal. That’s why many borrowers go for the sub-prime loan.
Unluckily, the bull market of the real property in US peak at the HPI (house price index) 206.52 on July of 2006. After that, HPI has been decreasing till 167.69 on June 2007 with the decreasing rate of 18.8%.The HPI still decreasing until today. This makes most of the sub-prime loan default. Borrowers can’t sell their house with higher price and not afford to pay the loan with higher interest rate of 5%-3% in 2007.
When the underlying sub-prime loan default, CDS holder will need to compensate the CDS seller. This is why one of the world largest insurance’ group AIG get into trouble. At the same, CDO holder started making loss as their CDS value is decreasing rapidly and they can’t get the series of coupon payment. 2007 is the time where the sub-prime crisis occurs and spread to the world. Most of the CDS and CDO holder started to make loss and it’s become worst to face the fate of bankruptcy.
References:
http://www.the-privateer.com/rates.html
http://en.wikipedia.org/wiki/Main_Page
http://10persons.blogspot.com/
http://ckfstock.blogspot.com/
http://money.cnn.com/2004/11/10/news/economy/fed_rates/index.htm
http://www.bankrate.com/brm/news/fed/20010627e.asp
http://cforum5.cari.com.my/forumdisplay.php?fid=5
http://www.bloomberg.com
http://www.myhome.ie/residential/advice-centre/1014-1104-2317/house-price-index-2007.asp
This is the result of my analysis and research.
Didn't really need this for my assignment but just for my knowledge.
Please do some correction if there is any mistake or grammar error.
Still in my learning process to master English and my core subject.
MR.8
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