If you lost your money in the market crash of January 2008, here's the route to your loss, in chronological order.
2001-2005:House prices in the US begin to rise rapidly. Banks lend aggressively and create a subprime industry.
Sub-prime lending refers to lending (at slightly higher interest rates) to people who may not be eligible for a loan under normal circumstances. Maybe they don't have a regular job or income, or have defaulted in the past.
Banks traditionally did not lend to such people due to high risk of default. But since these loans were mortgaged against property and property prices were rising continuously, banks started doing so. If customers defaulted, they good sell the mortgaged property.
2005:The booming housing market halted abruptly in many parts of the US.
2006:Prices are flat, home sales fall.
February 2007:Sub-prime industry collapses in the US; more than 25 sub-prime lenders declare bankruptcy, announce significant losses, or put themselves up for sale.
While they were lending, banks did not factor in the possibility of a fall in property prices. When theFederal Bank (the US equivalent of RBI) started increasing interest rates, the sub-prime borrowers started defaulting and banks started selling off the mortgaged properties. As more and more properties came into the market for selling, the property prices fell.
August 2007:Many leadingmortgage lenders in the US filed for bankruptcy
March 2008:Bear Sterns falls.
September 2008:Lehman Brothers file for bankruptcy.Merrill Lynch sells off toBank of America.
Between 2001 and 2006, the US financial markets had developed a new product - a bond securitised against the mortgages.
In simple terms it means that themortgage banks borrowed money against the mortgages on the condition that they would repay to lenders as soon as they recovered their mortgages. The lenders in this case werefinancial institutions (like Bear Sterns, Lehman andMerrill Lynch) who in turn sold retail bonds to individuals.
Sadly, the repayment never happened. And institutions like Bear Sterns, Lehman, Merrill Lynch and AIG were the casualties. Since the mortgages were not honoured, the banks could not repay thesefinancial institutions who in turn could not repay retail investors.