The subprime crisis

Generations of Indians, not to mention people of other nations, have been fascinated by the American way of life. The American mantra for livelihood is Khayo, Piyo, Jiyo or put another way, consume, consume more and then consume even more. Guess what it led to.

Consider three things:
i) The Americans in general were not earning enough to satiate their enormous appetite for consumption.
ii) The U.S. Government encourages home ownership. Suppose a house costs $50,000 but you can afford $40,000 only. So you take out a loan of $10,000 from the bank. The bank charges a rate of interest and you pay EMIs.
iii) The housing market was booming; in other words if your house is worth $50,000 today, 365 days later it would be worth $55,000. So you can buy a house today, sell it off a year later when the price has increased, and pocket the difference. You would make a profit. But what if you currently have $40,000 in your pocket right now ? You go to a bank and take out a loan. A year later, you pay the bank the principal amount and $2000 as interest. You have the remaining $3000 to yourself. The principle here is that slightly less profit is better than no profit. Also, you can take out a mortgage on the house you are living in, i.e. the bank gives you a loan with your house as collateral. Since the price of your house would go on increasing year after year, there shouldn't be any problem.

So if you are an American as described in (i), chances are that you'd find the scheme outlined in (iii) pretty attractive.

Consumption in itself is bad. Now if you have added 'greed' to it, the result would be a deadly concoction that would eventually take down the world economy and result in millions of job losses.

Here's how the greed factor comes in: You are eyeing a house worth $50,000 due to reason(s) (ii) or (iii) or both. Normally you have to make a down payment which would be around 10% of the value of the asset (the house). Your bank balance is $2000 only and you have a poor credit history; in other words in the past you have defaulted on your credit card payments. Common sense would tell you to stop dreaming about the house, right ? Not so in the U.S.A. The bank would give you a loan, and would charge a very high rate of interest without even bothering to think whether you are capable of paying back the amount. This is known as subprime lending. The bank thinks that since they have your house as collateral, and since the price of the house would continue going northward for the next ten thousand years or so, they are safe. Also, they are going to sell these loans to investors and financial institutions (like Lehmann, AIG, ML) and make even more money. You are greedy because you want a house which you shouldn't have. The bank is greedy because it wants money no matter what.

It is evident that the schemes described in (ii) and (iii) would work only if the housing market continues to boom. It went bust. The primary reason for this was that a lot of people defaulted on their monthly installments. As more and more people defaulted, the house prices started going southward. This was the early signal for, to put it mildly, a catastrophe. The assets that the banks 'banked' upon, while giving out loans, were now worth peanuts. The big financial institutions found themselves not sitting on huge piles of wealth but on a mountain of worthless 'toxic' assets. Thus began the process that would ultimately result in the demise of the iconic American financial institutions which were known as the symbols of capitalism.