Subprime Crisis : What it really means?

The US Market was hammered by the SUBPRIME crisis recently and unfortunately right now, the problem is still going on. Investors are going wild on figuring out what’s going to happen soon. As you all know, when the US market sneezes, everybody else catches a cold. Being the largest economy in the world, whatever that happens in the US market, it will in some way impact the global market.

So, what exactly is SUBPRIME crisis? I’ll try, to the best of my limited knowledge, to explain in this post.

First thing is to know what SUBPRIME MORTGAGES actually mean.

Out there, there are a lot of loans/mortgages. All with different criteria and requirements. In the loans hierarchy, SUBPRIME LOAN is placed at the low end, i.e. subprime loans are given to people who have low credit rating. Here in Australia, they are known as “low-doc” loans. In Malaysia, I’m not so sure. If somebody out there knows, please put a comment down below.

Back in the 2003, US interest rate was really low. If I’m not mistaken, it reached as low as 1%. Now, that means, a lot of people were chasing the chance of securing loans for themselves. Of course, for those who have low-credit ratings, SUBPRIME loans are weapons of choice. These “cheap debts” start to become famous.

People now have a lot of money. This truckload of money was then injected back into the economy, creating a boom. Economy booms equal rising inflation. Naturally, US Federal Reserve will react to this by raising interest rates.

Guess what happens next? People are obligated to make repayments for loans they can’t afford. This means less money for the people to spend on other things which equals to lower economic growth (take note that consumer spending contributes to the economy’s GDP). Less people spending means lower revenues for companies which then results into poor company results. As you might have guessed by now, it will affect the share market pretty darn good.

I found out that only around 10% to 13.5% (2007, Inside Mortgage Finance; 2006, Mortgage Bankers Association) of all loans in the US are SUBPRIME but you need to remember one thing. It is infectious. Problems happening at one end of the spectrum will affect the other end. Lenders will now feel nervous and starts putting up higher interest rates because of the perceived increasing risks. This will also means more costs to businesses which leads to …. surprise surprise… laying off employees.

Now people have no jobs. No jobs mean less money to spend. Low consumer spending leads to lower economic growth (same as above).

Yes yes! Economy does go in circles.

People start to default. Less people are taking up new loans. What are lenders going to do? They need to raise interest rates for other remaining loans to cover their costs (in addition to above).

So, will this problem brings the US down to recession? I have no idea.

Recently, you may have heard in the news of the US Federal Reserve’s decision to lower the interest rate to ease the “credit crunch”. Is it working? I don’t have the answer to that either.

One thing to note though, these “cheap debts” are one of the reasons why we are in our current Bull Market. Will it be the catalyst to a start of a new Bear Market? Only time will tell.

P.S. For traders like me, am I staying out in the sidelines? Heck no! I’m enjoying the excitement! Though, I do hope things will get back to normal and the bull gets full control again.

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