If you are not a Rip Van Winkle impersonator, you must be hearing (and unfortunately, feeling!) a lot of heated, depressing news about Sub-prime crisis, credit crisis and the financial melt down. If the ambiguous and jargon based headlines about the financial crisis still fly mostly over your head, you are not alone, most of us are on the same boat of ignorance.
But this crisis is too important for all of us, and might have a drastic and prolonged effect on every facets of our personal and professional financial life. Following is a list of resources I gathered in last few weeks, which explains the current financial turmoil in comprehensible format.
What is Sub-Prime mortgage crisis?
The sub-prime mortgage crisis is an ongoing financial crisis characterized by contracted liquidity in global credit markets and banking systems triggered by the failure of mortgage companies, investment firms and government sponsored enterprises which had invested heavily in subprime mortgages. The crisis, which has roots in the closing years of the 20th century but has become more apparent throughout 2007 and 2008, has passed through various stages exposing pervasive weaknesses in the global financial system and regulatory framework. [Wikipedia]
Before you jump into the textual section, here goes the most simple and convincing explanation in a short whiteboard presentation by Marketplace Senior Editor Paddy Hirsch.
If you prefer a humorous approach to explain the dire situation, here goes your version:
The story begins with borrowers who have a poor credit history looking to buy a house and are prepared to pay a mortgage rate typically 2% higher than rates charged to people with good credit. Borrowers approach mortgage brokers or conversely get brokers to cold call them. Brokers match prospective borrowers with lenders who further lure borrowers with artfully crafted mortgages such as “no doc” mortgages, which do not require any evidence of income or savings. Big banks and wholesale lenders such as HSBC Holdings buy the debt, repackage them and sell them to Wall Street firms. Wall Street banks and investment houses further repackage these loans in mortgage backed securities (MBS) and collateralized debt obligations (CDO). These structured products very often yield high rates of return and are sold to pension funds, hedge funds and institutions.
Things initially went very well for the financial institutions that made these loans because in the years that followed interest rates stayed low, the economy continued to grow, and the real estate market continued to expand causing the value of most people’s houses (including the sub-prime borrower’s houses) to go up in value pretty dramatically. This made it relatively easy for these borrowers to make payments on their loans as if they ran into financial trouble they in more cases than not could tap the equity in their home (which came from the increase in the house price) to refinance at more favorable terms or to make their mortgage payment.Because a relatively few of these sub prime borrowers were defaulting on their loans, the financial institutions which held these loans were enjoying the additional profits earned by charging these borrowers a higher interest rate, without many problems.
As house prices dropped eventually, the equity value of home mortgages goes down, this creates an increase in mortgage defaults which will cause a further drop in house prices. This positive feedback relationship will simply create a snowball effect until the economy has reasons to believe that there are reasons for the reverse to happen. The snowball effect started from that point.
How Sub-prime became a worldwide epidemic?
When the analysts and experts talk about the current financial crisis, they often refer to “credit default swaps.” So, what exactly is a credit default swap? Marketplace Senior Editor Paddy Hirsch goes to the whiteboard for this explanation.
Sub-prime crisis impact timeline from Wikipedia
Who Is To Blame For The Subprime Crisis? by Eric Petroff at Investopedia
Paddy Hirsch explains how banks have gotten frozen in their tracks, awaiting a rescue.
Effect on Small & Medium Size Businesses and Startups
Most of the SMEs, all over the world, tend to finance their working capital by debt or loan or overdraft from banks. Due to the deep rooted and vastly spread nature of sub-prime crisis, banks from all over the world facing an unprecedented situation of asset reduction and lack of liquidity. A lack of liquidity means banks are being more selective and cautious about lending money. Banks often see small businesses as more of a risk, and due to the current financial condition, the level of caution is increased rapidly, resulting into both increase in interest rate (as in UK) and a higher number of refusals. Due to this tightened lending standards for commercial and industrial loans to small firms the access to capital for SMEs is getting reduced significantly. Due to the same reason, option of financing through equity for SMEs are getting limited as private investors are also either affected by the financial crisis or taking precautionary conservative steps.
Effect of the financial crisis already started hitting the technology market. Sequoia Capital, one of the biggest VC firm of Silicon Valley, gave a presentation to its portfolio company CEO’s last week. It’s a long, 56 slide Powerpoint message of doom and gloom in Silicon Valley which starts with “RIP Good Times”! Jason Calacanis, a veteran serial entrepreneur, calling this situation as (The) Startup Depression. In the same article, Jason shared some useful survival tips for startups and SME’s during financial turbulence. Singapore based tech-community evangelist and VC Bernard Leong shared his viewpoints in a blogpost Entrepreneurs and Credit Crunch. TechCrunch started tracking of layoffs from tech companies.
In midst of this crisis of epic proportion, Paul Graham wrote an wonderful article – Why to Start a Startup in a Bad Economy , which starts with
The economic situation is apparently so grim that some experts fear we may be in for a stretch as bad as the mid seventies.
When Microsoft and Apple were founded.