The United States' subprime crisis has turned out to be bigger than previously thought and has

the potential to drag the world's largest economy into a recession.

And although there are varying opinions on whether the US could slip into a recession or not,
most economists do feel that despite the US Federal Reserve's rate cuts and the Bush
administration's $161-billion economic aid plan, chances of a recession are high.

Be that as it may, one thing is for certain: the losses from the subprime that financial majors
have incurred will take a long time to get over.

Given below, in the table, are the estimated losses that some of the world's largest banks have
suffered on account of home loan defaults in the US. The total figure adds up to over $76 billion
and does not take into account losses suffered by many other financial majors that had an
exposure to the crisis.

Four Indian banks -- State Bank of India [Get Quote], ICICI Bank [Get Quote], Bank of Baroda
[Get Quote], and Bank of India too have big exposure to credit derivatives, with the spreads on
these widening since international lenders turned risk-averse following the crisis in the US
subprime (or high-risk home loan) market.

Credit derivatives are instruments for which the underlying asset is a loan or a bond. Marking to
market means valuing a portfolio based on the prevailing market price.
Subprime losses till date

Bank Losses

Citigroup :$18.0 billion

UBS : $13.5 billion

Morgan Stanley : $9.4 billion

Merrill Lynch : $8.0 billion

HSBC : $3.4 billion

Bear Stearns : $3.2 billion

Deutsche Bank : $3.2 billion

Bank of America : $3.0 billion

Barclays : $2.6 billion

Royal Bank of Scotland : $2.6 billion

IKB : $2.6 billion

Societe Generale : $2.0 billion

Freddie Mac : $2.0 billion

Wachovia : $1.1 billion

Credit Suisse : $1.0 billion

ICICI Bank has the highest exposure of $1.5 billion. SBI has an estimated exposure of $1 billion,
BoI of $300 million, and BoB of $150 million. About 5-10 per cent of this figure could be the
losses that these banks could incur.

Understanding the subprime crisis

Just what is the subprime crisis? And why is it having such a decisive impact on the Indian stock
market?

Let's understand it. Take, for example, an American who seeks a home loan, but does not have a
very good credit rating. That essentially means that banks may not extend him a home loan.
Enter, another American with stellar credit rating and the willingness to take on some risk. Given
his good credit rating, banks are willing to give him a loan at a certain rate of interest.

This individual the divides the loan into small lots and gives them out as home loans to lots of
Americans, who do not have very good credit rating and cannot get a home loan from any bank.
He gives out the home loan at a rate of interest higher than it is paying to the bank it borrowed
money from.

This higher rate is referred to as the subprime rate and this home loan market is referred to as
the subprime home loan market.

By giving out a home loan to lots of individuals, the individual ensures that even if a few of them
default, his overall position is not affected much. But the individual giving out loans in the
subprime market does not stop here. He does not wait for the principal and the interest on the
subprime home loans to be repaid, so that he can repay his loan to the bank, which has given
him the loan.

He goes ahead and securitizes these loans. Securitization involves converting these home loans
into financial securities, which promise to pay a certain rate of interest.

These financial securities are then sold to big institutional investors. The interest and the
principal that is repaid by the subprime borrowers through equated monthly installments is
passed onto these institutional investors.

The individual giving out the subprime loans, takes the money that he gets from selling the
financial securities and passes it on to the bank, he had taken the loan from, thereby repaying
the loan.

A neat plan. But then things went horribly wrong. The subprime home loans were given out as
floating rate home loans. So as interest rates increased, the rates on floating home loans too
went up, and so did the monthly installments needed to service these loans.

These high installments hit the subprime borrowers with the terrible force. Many, given their
poor credit rating to begin with, defaulted. Once, more and more subprime borrowers started
defaulting, payments to the institutional investors who had bought the financial securities
stopped, leading to huge losses.

So how did that effect stock markets in India? Institutional investors who had invested in
securitized paper from the subprime home loan market, saw their investments turning into
losses. Most big investors have a certain fixed proportion of their total investments invested in
various parts of the world.

Once investments in the US turned bad, more money had to be invested in the US, to maintain
that fixed proportion. In order to invest more money in the US, money had to come in from
somewhere. And this money came in from emerging markets like India, where their investments
have been doing well.

These big institutional investors, to make good of their losses on the subprime market, have
been selling their investments in India and other emerging markets. Since the amount of selling
in the market far overweighs the amount of buying, Indian stock prices have been falling.