layman’s understanding of the current crisis scenario in world economy

This document is created for people like me who are interested in world economy and related current affairs but are not much aware as they cannot follow all the terminologies in news and newspapers.

Currently there has been a downward trend in share markets all over the world which is being stated as an outcome of recession in US. Now we hear often that US economy is showing a down ward trend for which “sub prime” is to be blamed. Now what exactly is sub prime and how is that affecting the economy? The other day my husband found an informative article on Tata mutual fund website and tried to simplify and explain things to me. Now my venture is to try and put in words whatever little bits I have understood with my layman’s point of view.

To understand sub prime it is necessary to understand what is prime. Now prime and sub prime are terminologies related to loans. Now a prime loan is one taken for primary necessities like housing. Now in US there are certain eligibility criteria to apply for a prime loan.
a. You have to score 650 and above in their credit point system.
b. You have to possess a certain credit to equity ratio.
c. You have to make down payment of 20% of total hose valuation.
d. You have to have clean records in loans you have taken earlier in the sense that you have paid your installments timely…….and so on and so forth.

Now not all who wish to own a house match these criteria. However there are lots of houses which have already built and needs to get sold. In that case they apply for a sub prime loan obviously at higher interest rates. Now banks do not directly interact with individuals willing to apply for sub prime loans. There are organizations that serve as mediators between banks and individuals and charge both the banks and individuals for their work. At some point of time these organizations have smartly arranged such loans for a large number of individuals. Now a lot of the banks money is invested in such loans.

Now to understand the whole scenario first thing we need to understand is that where does bank get all the money from. There are several sources –
a. From peoples investments like fixed deposits and all, but that is not much.
b. Form shares…… and many more.

Now a very important such source is Bonds. This is basically a paper document where banks draw money from individuals promising them alluring returns in certain amount of time. For example, I invest Rs 10000 for 2 years and get Rs 12000 at the end of 2 years. Now these returns are subject to market related risks. To avoid such circumstances individuals go to Bond Insurers. These are organizations that provide guarantee on behalf of banks that if banks fail to produce the promised amount they will pay in return. Now the Bond insurances work like our medical insurances where we pay premiums of fixed amounts every year to get coverage against ailments up to a certain amount of money. What actually happens is that out of say 1000 premium payers say only 100 come up with claims and that is how these companies make their profits. Similar situations happen with bond insurers.

Now what happened in US in the current scenario is that a large number of these Sub prime debtors have failed to pay their credits in time. As a result banks are not being able to pay to the Bond owners. So bond owners are putting their claims to Bond insurers who are thus running in losses. So Bond insurers are getting back on banks and tightening their ropes there. To cope up with the situation banks are increasing their interest rates. Due this hike in interest rates corporate companies are not taking up loans as usual. As an outcome their production is less. As production is less supply is less/ prices are higher. So people will also buy less. As a result the rotation of money lowers. Also people will think twice before investing looking at the market trends. Again money inflow reduces. All this in totality leads to an economic slow down and recession.

This is the layman’s understanding of the crisis scenario.