Well. I think its time for me to pen down something concrete and really informative rather than let my perspective dictating the post. So here I have chosen the topic, responsible for gloomy faces in my cubicle and many sad news flashing in business channels. Please bear in mind that layman refers to this humble fellow and so dont be surprised if you find the explanation very simple and trivial.

Ok. Let me try to illustrate this jargon “Sub Prime Mortgage Crisis” with a rhyme which many of us know.

Jack and Jill went up the hill
To fetch a pail of water.
Jack fell down and broke his crown,
And Jill came tumbling after.

I feel this poem represents the current scenario very nicely. Therefore I am using it for explanation. So no offence meant to Jack if at all he happens to read this post.

“Jack and Jill went up the hill
To fetch a pail of water.”

In our case Jill is a very good fellow, honest and repays all his debts. Jack doesnt repay his debts on time or never repays. As per bank Jill is a prime customer.(True.Isnt such a customer important?) Jack is a way below Jill and so he is a sub prime customer. Now bank plans to provide loans to Jack inspite of his bad credit record. But loan to Jack was provided with a high intrest rate and taking his house as a collateral.Say if Jill’s interest for Rs.100 is 10 then for Jack it will be like 30.

Now the motive behind this decision is not so noble. Many might argue that this plan was adopted to provide loans for unfortunate people who could not afford to loans due to unavoidable bad credit history. I dont subscribe to this view. If that is the case what is the guarantee that the unfortunate lot will be able to pay higher interest? These so called unfortunate people would have been viewed as an untapped market. If Jack is able to repay his debt correctly banks could get high returns. Even if he fails, banks could take away the house and sell it for good profit due to the real estate boom. But the following evaluations went fatally wrong leading to the economic turmoil.

1)Risk evaluation was faulty. Annual income and other such criteria were not evaluated properly during loan processing. So Jack who earns Rs.5000 per month was projected that he will earn Rs.10,000 by next year.

2)Asset evaluation was faulty. The value or worth of the houses which were taken as collateral was projected high. Saturation of house prize in due course of time was not taken into consideration.

In nutshell people were too optimistic. They expected house prices to go on rising and simulatenously people willing to buy houses also go on rising. So that even when Jack defaults they can happily snatch his house away and sell it for very high price.

“Jack fell down and broke his crown”

Things started to change. Jack failed to repay the debts. Bank took the property and put it for sale. Suddenly many sub prime customers like Jack started to default and gave away the house to banks. So lots of houses came to a market. Suddenly there seems to be no buyers. Real estate bubble has bursted. Supply > Demand. So it naturally resulted in fall of house prices. The fall is so great that it burnt the fingers of banks.

“And Jill came tumbling after.”

No funds were available in banks. Situation became so acute that loan was not even available to the prime customers. So it resulted in a situation where there is no finance for business expansions,start ups etc etc. Unfortunately it is not only Jill who came tumbling after but the whole global economy coming tumbling after.

PS: Please let me know if my comparison of the crisis with the rhyme makes the explanation confusing.