Subprime is the cause of USA Economy slow down. It is the very popular news among everyone and it is become very serious then expected. It caused more damage to all the industries especially Banking, Insurance and Automobile sectors. Subprime crisis caused big loss to the banks and now it is affecting the other industries like Auto Mobile companies (GM, Ford, etc.). In this blog I will write about what exactly is the Subprime crisis and why USA banks created such a big mistake in their era. Some experts comparing this disaster with the 1930 Economy slow down in the USA.
What is Subprime lending?
Subprime Mortgage Loans (or housing loans or junk loans) are very risky. But since profits are high where the risk is high, a lot of lenders get into this business to try and make a quick money.These loans are given to people who have inability to repay the loan and they don’t have stable income. For example , a person who is working on IT company earns Rs.40000 per month and he doesn’t have any other income or assets. When the bank gives him loan of some lakhs, the EMI for the month would be Rs.20000-Rs.30000. If he lose the job, there is no possibility for him to pay the EMI, he will just surrender the house to bank and go away. This is the one simple example how Subprime problem starts.
Who opt for Subprime lending?
Individuals who have experienced severe financial problems are usually labeled as higher risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually these events were unforeseen and cause a major setback in finances. As a result, late payments, charge-offs, repossessions and even foreclosures may result.
Due to these previous credit problems, these individuals may also be precluded from obtaining any type of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not occur.
What caused 2001 recession?
Subprime problem is more severe then what we saw in the 2001 recession. The real fact is that, 2001 what happened is Dot Com Bubble followed by the recession. Since the invention of internet, there is dozens of new companies coming up with the Dot Com dreams. There is lot of hype around Dot Com is that any company can make the billions of dollars. So, people started investing more on the Dot Com companies and the prices of the share value is increased dramatically. The price of the stock market is over valued. A small company without any profit valued as a billion dollar company. Even they don’t have clear idea on how will they make profit.
To keep running the company, they are spending investors money and promising that they will make profit in future. After some period of time, investors realized that company is not making any profit and stared selling the shares. When selling shares is more than buying shares, the value of the share will be coming down. It caused sudden fall on the stock market and the companies tumble to survive. Dozens of small companies vanished and only few big companies like Yahoo, Amazon, ebay, etc. has managed to survive on the burst.
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So, whoever working on Dot Com companies lost their jobs immediately, when there is increase in the unemployment will decrease the country’s GDP growth. If there is two quarters continuous fall in the GDP, it is called as recession. This is what happened in the USA’s 2001 recession. What we are seeing as Subprime is different from the 2001 burst.
Subprime Crisis and Banking Industry
Subprime crisis has ended history of many banks in the USA. As of now 22 banks closed because of Subprime crisis. It is started with the Lehman Brothers, a 138 year old company filed bankrupt. It is followed by Washington Mutual Funds. Like this 20 other small and medium size banks fallen easily. American International Group (AIG) survived by giving the $80 billion bail out money by the USA government. Another major collapse with Citi Bank which has written off $60 billion as the bad debts. CitiBank also rescued by the USA government using bail out plan. It is estimated that USA needs atleast $800 billion required to handle the Subprime crisis. It is not yet over and now the Automobile companies are struggling. You can read that in the next section.
Survival of Automobile Biggies
Now the turn is Automobile industry and it is affected more than any other industry in the USA. The major three companies in the USA, General Motors(GM), Ford and Chrysler needs help from the government to survive. The discussion is going on and the decision will be taken by the next week. The fall of automobile companies will be more, so it is expected that government will come to the rescue. i will write the another post on details of how automobile companies went into trouble.
I hope you have enjoyed reading this article. I have referred many sites to get the knowledge of Subprime lending and once I have read a book named “Dot Com” which helped me to understand the 2001 recession in better way. It is because of the USA governments mistake, the entire world is jolting on economy crisis. It is expected that this down turn will continue for the next 1-2 years minimum. Every company is now looking for the cost cutting measures and plan to spend efficiently. This is going to be good lesson for USA Banks and they need to learn from Indian banks. Of course we are doing pretty much better than other countries. Thanks for reading this article.
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If you have any thoughts on the above books, please post it in the comments section. Also if you have feel any other good books on the same subject, share with us.