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Since the last few months, we have heard a lot terms like 'credit crunch', 'sub-prime mortgage crisis', 're-pricing of risk', etc., which are sometimes difficult for non-finance background people to understand. In this article, I will try to make sense of these things in simple language.

The whole system works like this. Banks take deposits from people on which they have to pay interest. To earn their income, these banks then lend the money to people who need them at a interest rate higher than they pay, thereby, earning their income. Since 2001, the interest rates in US were very low which led to US banks having lot of money. The money which lies with a bank (other than that required by regulations) is like a dead-wood, it doesn't earn anything for the bank. So banks are desperately in need for avenues to look for investments.

Obviously, when the banks have lot of money, the first place of investment are ventures (people or commercial enterprises or propositions) with good standing. But when there is lot of money, the banks tend to look for avenues which happen to be more risky. What the banks in this case did was offered loans to people who had bad credit history or less income, to purchase houses.

From the month of July 2007, the credit market started to collapse as financial panic spread the world over, the reason being 're-pricing of risk' - a phenomenon when assets that were fundamentally sound are hit by 'supply demand imbalances' in the market. As a consequence, liquidity evaporated and market turmoil in a risky sub-sector of the US mortgage market spread to impact market conditions globally. Such loans were called NINJA Loans, i.e., loans to people with No Income, No Jobs, and No assets.

To entice these people to avail themselves of loans, the loans carried an interest rate which was below the prime-lending rate (rate at which banks normally lend). Apart from that, various innovative methods were devised like initial low rate and later on a teaser rate which is few points higher than initial rate (other such products are 2/28 loans, balloon mortgage, piggyback loan, etc.)

Now, it would be stupid of banks to have such 'risky' loans on their own portfolio. So they turn these loans into securities which can be sold to investors (in 2006, $ 450 billion worth of such loans were converted into securities). A security purely consisting of a ninja loan is risky in itself, so there investment bankers come to the rescue. They bundle such loans with other types of debt like credit card and auto loans and call the end result as an 'asset backed security'. These securities are then bought and sold in the commercial paper market.

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* Contributed by: -
Vijay Singh Poonia,
PGDM 2007-09,
IIM Calcutta,
Has work experience of 3 years with Indian Oil Corp Ltd.