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The word ‘sub-prime’ refers to borrowers who do not have sound track record of repayment of loans (it means such borrowers are not ‘prime’ thus they could be called as ‘less than prime’ i.e. ‘sub-prime’). The ‘sub-prime crisis’ which has been echoing time and again recently has its origin in the United States housing market by Late 2007—being considered as the major financial crisis of the new millenium.
Basically, the period 2000-07 had seen a gradual softening of international interest rates, relatively easier liquidity conditions across the world motivating the investor (i.e., banks, financial institutions, etc.) to expand their presence in the sub-prime market, too. The risks inherent in sub-prime loans were sliced into different components and packed into a host of securities, referred to as asset-backed securities and collaterised debt obligations (CDOs). Credit rating agencies have assigned risk ranks (e.g., AAA, BBB, etc.) to them to facilitate their marketability. Because of the complex nature of these new products, intermediaries (such as hedge funds, pension funds, banks, etc.) who held them in their portfolio or through special purpose vehicle (SPVs), were not fully aware of the risks involved. When interest rates rose leading to defaults in the housing sector, the value of the underlying loans declined along with the price of these products. As a result institutions were saddled with illiquid and value-eroded instruments, leading to liquidity crunch. This crisis of the capital market subsequently spread to money market as well.
The policy response in the US and the Euro area has been to address the issue of enhancing liquidity as well as to restore the faith in the financial system. The sub-prime crisis has also impacted the emerging economies, depending on their exposure to the sub-prime and related assets.
India remained relatively insulated from this crisis. The banks and financial institutions in India do not have marked exposure to the sub-prime and related assets in matured markets. Further, India’s gradual approach to the financial sector reforms process, with the building of appropriate safeguards to ensure stability, has played a positive role in keeping India immune from such shocks.