You would have read about the ominous rumblings in the US’ Sub prime market. Bourses across the world including those in India have dipped in response, and trade pundits are saying the worst is still to come.

So the major question on your mind would be: a) What is it all about?; and b) should you be bothered?

Lets answer the second question first: Yes, I think you should be bothered. But first be clear as to what it is all about.

‘Subprime lending’ as the terms itself indicates, is lending money to underqualified borrowers. There are a lot of borrowers who have bad credit history, loans to them would be categorized as subprime loans. Then there are those who do have a good credit history but do not wish to disclose essential details about their assets and financing, these too are placed in the sub prime category. Subprime lending is much more risky as the chances of default is comparatively higher. It is also much more lucrative as lenders charge much more citing the above reasons.

During boom times these markets can be extremely profitable as the chances of defaults goes down as there is enough money in the market for everyone. But when the situation reverses, and the economy goes into a depression, it sets off a series of defaults that can cause havoc in the market. If A has borrowed from B and then lent it to K, then A would not be able to pay back his money to B if K defaults. Thus A and B both will be affected if K defaults on his payments.

This is what is happening in the American market right now. Many people who did not have enough assets to back their loans borrowed money to buy houses during the housing boom. Often these prices were grossly inflated. They believed they’d be able to sell the houses to someone else for still higher prices. So when the housing bubble burst, these people were left with houses they’d brought at high prices and with loans they were not able to repay.

They thus became the first to set of the chain reaction which slowly is overtaking the entire US debt market. All those funds that were exposed to the housing market are now suffering crippling losses. Bears Sterns and PNB Paribas has suspended operations of those hedge funds that were exposed to the housing markets.

Now these are really large financial institutions. They have operations spread all over the world, especially in the developing world, which includes India. Their losses in one market would make them tighten credit in other markets like India. So all those companies that had been banking on them to supply money for expansion/acquisition plans would be left high and dry without any funds. Interest rates, floating interest rates would go up, increasing the cost of loans for all the companies. Not only will this in turn affect the bourses which will lose heavily, but can also have a trickle down effect on the prices of day to day commodities. So if you are a person who invests in trade markets you should tighten your seat belts as there are losses in store for you. Even if you just a salaried person you should worry because sooner or later prices would go up because of this crisis.

But do not worry unnecessarily. We have not reached the stage where commodity prices starts to go up. Who knows we may not reach that stage at all.