The Sub-Prime Crisis - Why Did the Stock Market Crash in 2008?

The belief that the US market and economy is known for its optimum capitalization of whichever opportunity comes their way, was further reinforced by the roll-out of the Sub Prime Loans in the year 2007-2008.

It was indeed a novel scheme to begin with, but had far-reaching consequences not only for USA but for the entire world economy.

The all-powerful and influential USA went onto to face an economic turmoil which created further fiscal disturbances in countries largely dependent on exports from the US.

What Triggered This Novel Scheme?

The 2007 real estate market saw a boom like never before. Everyone wanted to invest in property, but those who had access to credit facility in terms of loans from financial institutes had an upper hand over the people whose credit rating was low due to lack of job security, non-repayment or delayed repayment of previous loans.

Nevertheless, the desire to invest in real-estate was mutual. Coupling the aspirations of the masses along with the profit motive, the banks in the USA introduced the concept of the Sub-Prime Loans.

What are Sub-Prime Loans?

They are Loans given by Financial institutes and Banks, to those individuals who have a poor credit rating, don’t qualify for a loan or those with lack of job security.

These loans enable the masses to fulfil their aspirations in terms of purchasing their desirable assets.

Short-term Impact of Sub-Prime Loans:

These loans provided further stimulus for borrowing. The increase in number of investors benefited the already flourishing real-estate market.

The driving force for the banks was the rate of interest that was increasing because on one hand the demand for the loans kept increasing but on the other hand there weren’t enough players in the loan sector to meet that demand. However, later the lucrative profits drew several banks to jump onto the bandwagon of sub-prime loans.

The banks that were rolling-out the scheme were able to recover their loans even with higher rates of interest because the borrowers also witnessed a surge in rent and resale prices.

The Borrowers were not only satisfied by their aspirational purchases but were able to improve and establish better credit ratings by timely repayment of their loans. The timely and efficient payback behaviour would act as a precedent and leverage their cause for future lending’s.

Long Term Impact of Sub-Prime loans:

Jumping onto the bandwagon in an early stage may be beneficial, but at a later stage it may not be as remunerative owing to over-saturation.

The same thing happened with the Sub-Prime Loan sector, the popularity of the innovation gained ground with the all the banking players thus, supply overshot the demand and from there the downfall begun.

The rates of interest along with the property prices took a hit. The real-estate business was no longer as rewarding. Property rents and resale value depreciated. 

Owing to all these reasons, the borrowers were finding it increasingly difficult to repay these high interest mortgages. Number of defaulter loans shot up. Only those who previously had good credit rating were able to repay in full, rest of the loans became non-performing assets for the bank.

The severity of the defaults was such that many well-known banks had to declare bankruptcy.

One such financial institute was The Lehman Brothers, who were the climax of the sub-prime crisis when filing for bankruptcy.

Impact on Indian Economy:

The Indian economy was not severely affected because India’s GDP was dependent on its own domestic sources and not on exports from the USA. In the early 2000’s, India’s exposure to the mortgage market was also negligible compared to other developing countries.

What did affect the Indian economy was that the fiscal deficit went from 2.7% to 4% in one financial year. India was faced with a fiscal deficit as well as a current account deficit (CAD).

The further increase in the CAD was responsible for the devaluation of the rupee.

Indian banks and financial institutes were also faced with the problem of loan defaults and non-performing assets.

India released NRI bonds in the hope of improving the fiscal deficit scenario and for the purpose of increased cashflow in the nation to sustain the sinking economy.

Who is to be Blamed for this Market Crash?

Whenever something goes wrong, everyone starts pointing fingers at each other. When that something that goes wrong includes money, the intensity of the problem increases 10-fold, attracting global attention.

A similar thing happened in 2008, but there isn’t one person, one bank or one financial institute to be blamed for the market crash. It was a collective creation of the world’s central banks, lenders, credit rating agencies, underwriters and investors.

The disastrous market crash of 2008 led the New World into a large-scale recession. People lost their jobs and their life savings. Banks were forced to declare bankruptcy. Investors lost out on huge profits.

This market crash of 2008 had indeed been a reminder for all those big-players of the market to be prudent while dealing with people’s money and judiciously come up with inventions whilst keeping current market trends in mind. The study of the longer run and futurist trends also should form an important criterion while rolling-out new ideas.

The 2008 housing market crisis still holds relevance as it sets a precedent for the major- players in the financial set-up.

 

Written By - Tushna Choksey