By Sanjay Matai

The tsunami of the US subprime problem has been wreaking havoc on financial markets across the world. Almost every investor – whether in debt or equity – is likely to be affected by it.

What exactly is this subprime problem?

Put very simply, subprime loan is lending to people who may not be eligible for a loan under normal circumstances. Maybe they don’t have a regular job or income, or have defaulted in the past.

Hence, banks traditionally did not lend to such people due to high risk of default. But they did start doing so, charging higher interest rates to offset risk. In fact, they even came up with a ‘no documents’ loan where people did not need to show any evidence of job or income.

To an extent, this lending was OK, since these loans were backed by mortgage of the property financed. So, if the borrowers defaulted, banks could always confiscate the property, sell it and recover their loan.

But they made some mistakes. For one, they paid no heed to prudential norms. Also, they did not factor in the possibility of a fall in property prices. As the Federal Bank (the US equivalent of RBI) started increasing interest rates, these subprime borrowers started defaulting. As more and more properties came into the market for selling, the property prices fell. Higher interest rates had already affected demand even from prime borrowers, further compounding the problem.

Loans could not be recovered, and several firms specialising in mortgage had to shut shop.

What made this a worldwide phenomenon is the fact that many such small loans – both prime and subprime – were sold to investors all across the world. As they were secured by property and also offered higher interest rates, insurance companies, pension funds, hedge funds, etc invested heavily into these debts. Since these investors are spread across the world, the US default problem has worldwide effects.

How are you responsible?

Let us look at things in a broader perspective.

It was greed that motivated banks to lend to subprime borrowers, despite being aware of the possibility of high default. Short-term profits, fat annual bonuses and high share prices (in which they had stake too) propelled banks' management, thus compromising on long-term future.

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The author is an investment advisor and promoter of wealtharchitects.in. He can be reached at sanjay.matai@moneycontrol.com.