“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” so said Warren Buffett, reportedly the third richest person in the world, in 2002. His prophetic words are becoming true with the unravelling of the financial mess created by the sub-prime lending spree in the
What are these sub-prime loans? Philanthropy or usurpation?
Sub-prime loans are those given to borrowers whose creditworthiness is below prime and hence are of low quality. Sub-prime or low quality loans are mainly of three kinds: car loans, credit card loans and house mortgage loans. The sub-prime loans were given to borrowers who did not have the capacity to service them (pay interest and repay principal). At the height of such lending, it was said, the borrowers were in the NINJA (no income, no jobs also) category. To lure such borrowers, some lenders adopted ‘predatory’ practices. They lent deliberately knowing that there will be default (surrender of the mortgaged commodity by the borrower) and, when it occurred, seized the houses mortgaged and sold them off to make a profit.
The basic question is why would any lender (apart from the predatory ones) give loans that carried the highest risk. One reason is that these carried higher interest rates. But, the main reasons seem to be two: large surplus funds with banks and the introduction of esoteric financial instruments that passed on the risk to unsuspecting investors.
Soon after the dotcom bubble burst in 2002, the Federal Reserve (central bank) of the
The birth of the monster
The lender hoped that even if the borrower could not service the loan after two years, he/she could always take refinance (raise a fresh loan against the same house) for a larger amount. Implicit in this was the assumption that house prices will go on increasing. This premise got a jolt when house prices started climbing down after peaking in 2005-06. The primary lenders (originators) of the sub - prime loans wanted to sell the loans to investors. To make them attractive, they pooled such loans into baskets and created what are known as CDOs (collateralized debt obligations). The baskets were sliced and spliced to make layers of CDOs (derivatives) carrying different risks. The underlying assumption was that all borrowers would not default at the same time and a percentage of them would be prompt in payment. The ‘safe’ portion was sold to investors averse to high risk and the balance to others. The credit rating agencies put in their might behind the manoeuvre by giving the best rating to the portion deemed low risk. Some even alleged that the agencies helped in the splicing game. The whole arrangement crumbled when things turned adverse with falling home prices and rising interest rates , leading to a spate of defaults.
The potential danger
The estimates of the sub-prime market vary between $500 and $750 billion. It makes up 20-22% of the
As a result, confidence in the banking system was rudely shaken. And, no bank could be sure of the solvency of another bank and the inter bank money market, where short term lending was common, almost dried up. With the sub - prime loans taking different avatars and changing hands frequently, no one knows how widespread the contagion is.
As pandemonium raged in the
Evading the inevitable: Recession
With each of the past US recessions originating from a collapse in the housing market, the Federal Reserve has cut down its lending rates to banks, thereby, pumping fresh money into the market and avoiding a liquidity crunch(in the process ,perhaps creating another bubble). It has also bailed out several ill-fated lending institutions: to revive the confidence in the banking system. Even a division between the normal bank and the investment bank could auger well for the troubled sector. Ultimately, bankers will have to return to the time tested practice of prudence in lending if problems witnessed in sub - prime loans are not to recur.
Sudipta Mukherjee
