The saga of the subprime mortgage muddle

“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 U.S. The developments will also affect emerging market countries such as India. The developments that led to the explosive situation are traced here.

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 U.S. pumped in money into the system. Too much money in the system led inevitably to lower quality of lending. The availability of credit derivative instruments, which basically transferred the risk to another party, accelerated the pace of sub-prime lending.

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 US home loan market! Even a small number of bankruptcies could be devastating. In early 2007, New Century Financial, a large sub-prime lender, collapsed. In February, HSBC, reported steep losses in sub-prime lending in the U.S. Many Canadian, German and French banks followed suit. Many of the big investment banks in the U.S. also reported large losses.

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 US stock market, with stocks plummeting and many investment banks and hedge funds throwing in the towel, a grave apprehension of the crisis infecting the emerging markets loomed large in august,2007. Following the dotcom bubble bust in 2002, a majority of the investors shifted their focus to markets like India and China, which were relatively more immune than the European Union. This led to a surfeit of rakish funds in these markets. But this time, the Central Banks of these countries have quite nimbly prohibited the entry of such doubtable investors , by curbing their investments through P-notes and by making them register as FIIs. So the emerging markets might have averted the disaster ,probably, to die another day. Still what cant be ruled out are such vicissitudes in the stock markets , that could be surpassed only by the anticipating heart of an ardent lover.

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