You know a word has entered into the popular lexicon when they leave the preserves of blue chip investment banking offices and become the stuff that people in the Mumbai local trains discuss. Suddenly news and television headlines are screaming 'sub-prime' at us and everything from inflation downwards is blamed on this phenomenon.

So what is the sub-prime mortgage issue about and what exactly happened in the US? Will India ever face a similar situation?

What is a sub-prime mortgage?

A sub-prime mortgage is a loan offered by a lender (say a bank like ICICI Bank [Get Quote] or SBI [Get Quote]) to a borrower with a poor credit history (meaning s/he has defaulted on her/his financial commitments in the past) against the security of her/his house property.

Such borrowers are called sub-prime borrowers.

Since the risk of default in such cases is high, these loans are offered at relatively higher interest rates compared to loans offered to people with a good repayment track record. However these sub-prime mortgage loans are relatively much cheaper than completely unsecured loans (credit cards or personal loans) to the same profile of borrowers. 

What was the US sub-prime crisis all about?

The US real estate industry witnessed a boom between 2001 and 2005, with property prices soaring to historic highs due to low interest rates and other factors.

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Some of the weaker borrowers, who were either on the verge of defaulting on their financial commitments (like their monthly installment on their home loans) or had already done so, owned house properties whose values had risen dramatically on paper. So lenders looking at increasing their profits were quick to spot an opportunity and lent money to such borrowers on the basis of this increase in the paper value of their homes. These loans were either used to repay the old loans or for other expenses.  All was fine till the housing party crashed.

Interest rates began to rise resulting in fall in the prices of housing properties. The rising rates led to a spate of defaults by borrowers (as had happened in India recently, banks in the US increased the EMI amount and borrowers having no repayment capacity failed to meet their monthly obligations), as a result of which several US sub-prime mortgage companies had to declare bankruptcy.

The result was that the shares of lenders dealing in sub-prime mortgages took a tumble. That's not all. The effect spread to the entire financial markets because these lenders had raised money on the basis of such loans and were now not able to pay them back.  And the ripple turned into a wave, affecting a wide section of the markets, and then spread overseas.

How good/bad is the sub-prime situation in India?

The US sub-prime crisis had a short-term impact on the Indian stock market and on credit instruments with overseas investments. Collateral damage in India was extremely limited, as Indian banks or financial intermediaries do not own much of these securities issued by banks in the US.

But could such a crisis emerge in India?

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In India, the market is more non-prime than sub-prime. Borrowers falling in this category may have never defaulted, but have low incomes or may not have proof of such incomes (like a small shopkeeper, who may not be able to show his income on paper). These people may have borrowed earlier, but from the local moneylenders and not banks or formal institutions.

These non-prime borrowers in India belong to the economically weaker sections of society, with monthly incomes of around Rs 5,000 - Rs 10,000. They may pay interest rates as high as 45-50 per cent on loans up to Rs 50,000, the reason being that default rates are always higher for such unsecured loans.

In fact, there are lenders in the unorganised sector who may charge interest rates as high as 4000 per cent per annum!

But despite the mind-boggling interest rates, non-prime borrowers still prefer their local moneylender to a bank.

Why? Let's understand with the help of an example.

Suppose a vegetable vendor borrows Rs 90 from a local lender in the morning and returns Rs 100 to him in the evening, which works out to an interest rate of 4,000 per cent per annum. The advantage for the vendor here is that he has continuous access to cash flows. A bank does not usually lend for such short periods as a day, which may not suit the vendor's needs.

There's another psychological reason. When a vegetable vendor borrows Rs 90 and repays Rs 100 at the end of the day, he feels he pays only Rs 10, instead of 4,000 per cent per annum. A longer-term loan with an interest rate of 40-50 per cent from a bank may feel too much for him. Even a daily loan at an interest rate of 4,000 per cent from a local lender may seem preferable!

And when it comes to repaying the loan, the vegetable vendor will repay the local lender, because he knows that if he doesn't, he won't get money the next morning to buy vegetables. His access to continuous cash flow will come to a halt. Also, the local lender may use muscle power to get his money back.

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As a result, large banks find it difficult to penetrate the non-prime market, and may prefer to leave it to the smaller banks and NBFCs.

The percentage of defaults in this segment have now climbed to double digits for banks and NBFCs active in this market, and has become a major cause of concern. And they are finding that sending recovery agents to recover loans may be harmful for their reputations.

In fact, recent reports suggest that ICICI Bank is likely to exit the non-prime personal loan business because of the high reputation risk the business poses.

In India, it is still difficult to get a loan even against a security (home, etc), if a prospective borrower has defaulted earlier. Owning immediately encashable security like jewellery or stocks might make it a little easier, but not much.

If borrowers lend indiscriminately, and lenders default in a big way, a crisis is certainly possible. But that looks unlikely for now in India.