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Sub prime woes explainedd simplistically
Explaining Sub Prime woes
Consider you are going to buy a property for 120 rupees. You were to fund it with Rs 20 of your money and for the remaining Rs100 you were to take a loan from bank A. The bank gave u the loan knowing that your income is Rs 4 per month. They were charging a interest rate of 10 % p.a that works out to Rs10. The tenure of the loan was 10 years. So the total of principal and interest would come to Rs 200 over 10 years which means Rs 20 per year. This resulted in you paying Rs 1.66 per month as your installment. Now that was okay considering your income per month was Rs 4. Assuming that the bank had only one customer and that is you. They would show in their balancesheet that they have given u Rs100 and are earning 20 rupees cash flow every year for the same.
Now consider what would happen if the price of the underlying went frorm 120 to 100. over a three year period. So now w r in the fourth year and the value of the property is now Rs100. The bank now knows that it is trapped. If u default on the loans for any reason they will have recovered only 60 rupees from you. ( this is the yearly outflow of rs 20 multiplied by 3 years ). The bank ha survived its operational expenses with the help of Rs 20 that u paid every year. The property is now worth only Rs100. The catch comes in here, and understand it properly. At the start of the 1st year when u went to them for loan they had Rs100. Now at the start of the fourth year they have just 1 property worth 100. Now the bank needs to function doesn’t it?. So from where is it going to pay for its expenses ( staff, rent etc ). They only have a property worth Rs 100. Now a buyer will not be willing to pay the bank Rs 100 for the property because it knows that the bank is desperate as it needs the money and that will drive the price of the property down further. The price at the end of the fourth year will go down to Rs 80. Assuming that the bank survived the year with the central banks help ( read lossening of rates, as happened yesterday). But you see it may see another year but ultimately it will have to offload the property in the markets the faster one does it ( the bank admitting its mistake ) the better off it is. But if they do so then they will have to show major loss I the year they do it Now no bank is ready to do it. Till we see major lossess being reported by these hedge funds the problems going to be there. Good medicine for any ailment they say is bitter
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