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.