Subprime mortgage financial crisis

What is subprime lending?
Sub-prime lending usually refers to the practice of giving loans to those who do not qualify for regular loans at market interest rates because of their poor credit history. Due to the increased risk associated with the takers, sub-prime loans are offered at a rate higher than market rates.

These loans are risky for both, those who are giving and those who are taking, because these combine high interest rates, bad credit history, and often, murky financial situations of the takers.

What caused the subprime mortage financial crisis?
The current sub-prime mortgage meltdown in US refers to the rash of sub-prime housing loan defaults that began in late 2006 and has continued into 2007. The sharp rise in foreclosures has caused several major sub-prime mortgage lenders to shut down or file for bankruptcy, leading to the collapse of stock prices for many in the subprime mortgage industry.

About 21% of all mortgages between 2004 and 2006 were sub-prime, up from 9% during the previous eight years. By 2006, sub-prime mortgages totalled $600 billion, accounting for about 20% of US home loan market.

In depth analysis of the crisis
Over the past few years, the issue has become more complex, as policy interest rates went to historical lows. The surge in liquidity was compounded by the economic recovery over the next few years and the boom in commodity prices. As crude oil rose to new highs, it poured into the already swollen corpus of the major oil exporters’ funds. With higher prices for commodity producers acquired vast pools of cash.

And with defined contributions becoming the norm across Europe, inflows into pension funds swelled. To top this off, the current account surpluses of East Asia piled up trillion dollar hoards.

So funds went hunting for yields and arbitrage opportunities - borrow cheap in yen and buy high yielding Australian, New Zealand and other securities.

There was of course much more. With so much liquidity sloshing around and all kinds of assets trading well, the collective euphoria is easy to understand. The price of risk plummeted across the board.

Some time around 2003, mortgage lenders branched out big-time into lending to people who would not normally qualify for lending.

The bet was that with house prices rising, the value of the underlying security offset potential credit losses. It became a booming business: people whose income background would not stand scrutiny bought houses they did not need and could not afford. Some took second mortgages on their existing homes to do up their kitchen just because someone was willing to hand them cash.

This was subprime debt.

Now remember, the borrower typically is low income, with negative savings and even if able to service the loan at 1% interest, is in no position to do so at 8 times that level.

So the house is foreclosed and auctioned. In the old days, this used to be called usury. These days it is known as predatory lending. However with so many homes coming to market, prices plummet and the collateral starts looking very scrappy.

Does the subprime crisis have the potential to become a full-blown debacle that can sink the world economy?
Commercial banks’ direct exposure to subprime mortgages is extremely low. But banks, along with other financial institutions, are exposed to subprime mortgages through derivative instruments known as collateralised debt obligations (CDOs). But the total volume of CDOs outstanding from US-based issuers is not a very large share of the aggregate value of marketable US financial assets. Banks hold the lion’s share of CDOs but only 17% of the CDOs have been created out of subprime mortgages. So how could a problem in subprime mortgages rock the international financial system?

Hedge funds hold the riskier part of the CDO tranches. Their holdings of CDOs form a high proportion of their portfolios. As a result, hedge funds are extremely vulnerable to a problem in subprime mortgages. The other, more important part of the answer is that hedge funds happen to be highly leveraged. With high leverage, a small drop in the value of assets suffices to create bankruptcy.

The vicious spiral that then sets in is by now distressingly familiar. The perception that a hedge fund is on the verge of bankruptcy triggers redemption calls from investors. Lenders too want their money back. This forces the hedge fund to liquidate assets.

When this happens at several hedge funds, there is a wave of selling. Panic grips the markets quickly. Risky assets begin to get dumped as investors seek refuge in government securities. All of a sudden, assets become highly correlated. The risk management models that financial institutions use compel them to reduce market exposures. This leads to more selling, more bankruptcies.

Subprime lessons for India
A need for credit rating even in the personal loan, or retail financial services, market. The Indian personal credit market has still retained vestiges of the old, inelastic interest rate system where, for the same loan amount, a man with a successful repayment record pays the same interest rate as somebody who was either taking out a loan for the first time or has an erratic repayment record.

Here’s another example: Indian banks offered the same interest on housing loans, irrespective of whether you had other loans running concurrently or your salary was inadequate to meet the repayment burden for your car loan. Credit shopping is common in if you already had taken a loan from Bank A, you could take another one from Bank B without A knowing about it. And, when you defaulted, it hit all the banks equally hard.

The Reserve Bank of India has made some progress by approving the launch of the first credit information bureau Credit Information Bureau of India (Cibil).Cibil is still in its formative stages and the regulator is still groping his way about the whole process. There are many regulatory gaps that need to be ironed out before the whole process can start yielding productive results.

Firstly, there is an urgent need to regulate the credit rating agencies.

Secondly, banks currently provide all their customer, loan and repayment details to Cibil, which then processes this data to form an opinion on the borrower’s creditworthiness. This is likely to be extended to mobile phone companies, stock brokers and insurance companies. Callous data entry or even manipulation by one participant in the chain can skew the credit score of any borrower, leading other lenders to charge a higher rate of interest to the hapless borrower. Cibil should check the authenticity of the data submitted.

Finally,India should have more credit rating companies, as every developed financial system has more than one credit information company today. This is necessary to obviate the kind of issues that may occur in the example mentioned above. Multiple credit information companies use different systems to iron out the kinks and to spot aberrations in the data. The market, banks in this case, then decide which is the better, and more reliable, company.

---Sweta