WHAT ARE SUBPRIME LOANS?
Subprime mortgage loans are riskier loans given to borrowers unable to qualify under traditional , more stringent criteria due to a limited or blemished credit history. The default rate in these loans is much higher than prime mortgage loans and is priced based on the risk assumed by the lender.

WHAT WAS THE PROBLEM OF SUB PRIME LOANS?
With the increase in the interest rates by US Federal Reserves, the subprime lenders started raising their lending rates. This led to a fall in demand for such loans. To keep volumes up the lenders started relaxing their credit criteria of thye borrower. Wall street encouraged this behaviour, too, by bundling these loans in to securities. And was sold to pension funds and other institutional investors seeking higher returns.

The impact of the subprime mortgage has been magnified as they started being packaged with innovative financial instruments. From 2003 to 2006, new issues of such financial instruments increased exposure to subprime mortgage bonds. The securities packaging enabled institutions to mix good risk and bad risk debts all in one pot and label it as good low risk instrument. Therefore the financial institutions earned a higher rate of return on what seemed like a relatively low risk instrument upon which hedge funds such as bear Stearns leveraged to the hilt.

Hedge funds deploy leverage to enhance their exposure to markets. When things are moving in the right directions this results in phenomenal profits. However if they are caught in the wrong direction, they may end up eroding their entire capital. This is what happened to Two of Bear Searns Hedge funds recently, which placed highly leveraged bets on packages of subprime mortgage derivative products. When the value and credit worthiness of these bond packages was cut due to the subprime defaults, these funds received call from banks which had provided them funds to leverage their bets in the subprime market. In order to meet their commitment toward these banks, they sold a part of their portfolio in an illiquid market. The illiquidity ate in to their portfolios as their own selling led to a further fall in prices. The effect of this was it virtually wiped out the total value of the funds that had previously been rated as low risk.

IMPACT ON THE EQUITY MARKET
As the subprime woes continue, the stocks of the banks, funds and other financial institutions having exposure to such assets leading to fall in the broad markets. Also as the subprime markets go down, the hedge funds receive call from the banks to meet their margin commitments forcing the hedge funds to liquidate their portfolio. As liquidity moves out to safer assets, riskier assets like emerging markets start tumbling down.

Keywords : sub prime crisis, subprime loans, loans, risk loans, hedge funds, equity markets, subprime mortgage