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Friday, October 4, 2013

5-Years Old Story of US Subprime Loans: What it Teaches Today’s India

Reading a feature on the US subprime lending mess in a re-cent issue of the Financial Times that narrated how a small company in California offered services that can show a low credit-score borrower as an ‘independent contractor’ on its pay roll and also provide a payslip as ‘proof’ for a fee of $50 and give a glowing reference about him to the lender for an additional fee of $25—all to enable the low-rated home loan seeker to avail the loan, one wonders if American borrowers are in anyway different from their counterparts in India. A true globalization of the art of seeking bank loans! This commonality doesn’t end here: even lenders are reported to have made few checks about the creditworthiness of prospective borrowers while granting mortgage loans to such out-of-pocket borrowers. The net result is free flow of mortgage loans.

How all this happened
Anecdotes aside, today’s freely flowing information about the mayhem in the US subprime market raises a fundamental question: How come such a mature market allowed credit to flow so freely? And there appears to be no single answer, for it is a culmination of one leading to the other and ultimately the whole impacting the financial system with so much more synergy that it is today sending ripples all around the global markets. If one looks at the whole episode dispassionately, its origin can safely be traced to the US tech-stock bubble burst and the September 11 terrorist attacks that pushed the  US economy into recession in 2001. The Fed, taking a cue from the experience of the Japanese central bank’s inability to stimulate economic growth and shovel its economy out of deflation, in its anxiety—as reflected in one of the statements, “Even though we perceive risks (of deflation) as minor, the potential consequences are very substantial and could be quite negative”—to checkmate recession turning into deflation has undertaken a series of interest rate cuts. The lowest interest rate of 1% almost stayed for a year. The theoretical underpinning behind such series of interest rate cuts is obvious: they are expected to encourage housing and consumer spending till at least the business investments and the resulting exports pick up momentum, so that deflation can be kept at bay. 

But the continued low short-term interest rates, that too, for such a long period, overstimulated the US housing market, creating hype around real estate. Indeed, it is the increased appetite for house loans that was incidentally pampered by easy availability of credit and consumer spending against personal borrowings that has kept the US economy in good shape. It is not that the Fed executives were happy with such policies, for there was a nagging fear among them that such policies could possibly lead to distortion in the economy, but they felt helpless except to resort to such risks as there was no other way than to keep the deflation under check. That’s what indeed echoes in what Alan Greenspan had to say recently: “Central banks cannot avoid taking risks. Such trade-offs are an integral part of policy. We were always confronted with choices.” On hindsight, one may find fault with the Fed’s policies, but it is a fact that it is the same policies, which have helped the US economy grow steadily—without being affected either by deflation or inflation.  

Slack monitoring is the real culprit
It is, of course, a different matter that these very policies are today proving to be instrumental in messing up not only the US credit market but also the global financial markets. In fact, more than the policies per se, it is the overenthusiasm (or greed?) of the market players to maximize their returns on investments in a low interest rate scenario that led to such massive accumulation of subprime loans of poor quality, which could today generate systemic risk shaking up the world markets. The low interest rate policies of the Fed made Wall Street banks and the investors at large look for profitable alternatives. In this jamboree, home loan lenders, taking advantage of strong investor appetite for high-yielding securities, could easily sell their portfolios of high-return and high-risk home loans to Wall Street banks. These banks, in turn, could repack these loans into investment securities—collateralized debt obligation bonds—and sell to investors such as international banks, hedge funds, pension funds, university endowments, private investors, etc. around the globe. It is such easy availability of funds that encouraged lenders to reward their brokers most generously for generating volumes under mortgage loans. In the process, neither did the  lenders ask questions about the income levels of intended borrowers nor did they bother to verify the default history of the prospective borrowers. Neither down payment was an issue. Such easy flow of credit perhaps encouraged many to get away with deliberately misstating their incomes backed by fraudulent certificates in connivance with brokers and walk away with even multiple loans. Cumulatively, the origination of mortgage loans, according to one report, had almost touched an astronomical figure of $600 bn in 2005 and 2006 as against $160 bn in 2001. 

According to one version of the press, the level of scrutiny of earnings and verification of antecedents of prospective borrowers by the lenders was so poor that 45% of all subprime loans given in 2006 went  to such borrowers who had not even documented their income fully, which means they had an easy way of overstating their creditworthiness in order to avail of home loans. In short, the whole supply chain of financing— both up and down side of the chain—was inflicted with fraud: borrowers had lied about themselves to get a better rate and large loans, loan officers lied about terms of loans—very few were explained how interest rate under adjustable-rate mortgages behaves once the Fed returns to normal interest rates, they even lied to banks about the creditworthiness of borrowers, and appraisers lied about the value of properties involved. And yet, these poor-quality loans could be sold in the secondary markets that too, with appropriate rating from rating agencies, and merrily carry on the leveraged lending. That is what indeed Fed Chairman, Ben Bernanke said in his presentation to lawmakers: “The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud.”

What is ironical about the whole episode is that the very mechanism of distributing risk by bundling it into marketable collateralized debt obligations and selling to willing investors across the globe as a scientific tool for management of liquidity and interest rate risks, has itself created today’s contagion. Reports indicate that some such products used to sell the home loan securities are so opaque that markets could hardly evaluate their worth. Yet, investors have gobbled up the issues—tranche after tranche. Such was the hunger for these investments among those classes of private investors who, driven by stock market collapse and low interest rates prevailing between 2001 and 2004, looked for exotic securities to boost their returns. And, importantly, all this became possible only because there was no rigorous supervision of mortgage lenders. “We didn’t have that, and we’re paying for it now,” said Edward Gramlich, a Fed Governor, in Washington, which summarizes the whole episode aptly.

Consequences of slack monitoring
The net result of such delinquencies is: today subprime borrowers are defaulting on their loans. With falling house prices and rising interest rates, defaults have only touched record levels, for the current worth of the houses financed are far less than the mortgages. As a result, lenders are pushed into bankruptcy. Investment banks have suffered huge revenue losses. Some of the highflying hedge funds have collapsed—Bear Stearns is one among them. The once free-flowing liquidity in the global financial markets has suddenly dried up. The huge losses suffered by some of the big international European banks, such as BNP Paribus, NIBC, and IKB of Germany in their sub-prime mortgages portfolio—a class of high-return high-risk home loans of low creditworthy borrowers—have sent strong signals of credit risk that made the asset-backed securities market stand-still. The overnight borrowing rates have skyrocketed in the European inter-bank market. This made ECB inject €94.8 bn into money market to replenish the dried up liquidity and restore “orderly conditions in the euro money market.” Even this could not stop the systemic risk rocking the global financial markets. On the other hand, as a result of ECB’s intervention in the money market, the prices of government bonds—both in eurozone and the US have gone up with a corresponding fall in yields, while the cost of insuring a corporate default via derivatives has gone up. 

All this, in turn, transformed into a perfect storm of systemic risk causing havoc across the global stock markets. One after the other, stock indices tumbled down—the FTSF of the UK lost 1.83%, Germany’s Dax index lost 2% and France’s CAC-40 lost 2.17%. In the meanwhile, the European liquidity problems automatically spilled over to the US moving its benchmark Federal funds rate to more than 5.75%, as against the Federal Reserve’s target rate of 5.50%. The act of Fed staying glued to its stated objective of inflation control and, thus, not announcing the anticipated interest rate cut and the appreciating yen have perhaps cumulatively further worsened the gravity of the calamity that is already wreaking havoc in Asian and European markets. In the meanwhile, true to their nature, FIIs have started withdrawing their investments from emerging markets to sustain the losses incurred under subprime loan exposure.

The woes inflicted by the US credit market are so intense that even an infusion of $76 bn by the Fed into the troubled banks, could not arrest the free fall in the markets. On August 15, the Dow Jones industrial average fell by 167.45 points closing at 12,861.47, which, incidentally, is its first close below 13,000 since April 24. Many analysts are of the opinion that the current situation is more akin to the 1997-98 global financial crisis that pushed the  economies of many countries into recession but the US Treasury Secretary,  Henry Paulson,  is of the opinion that though some “entities will cease to exist”,  the market ‘adjustment’ will go on and the US economy will still keep growing. He averred that the current turmoil in the global financial markets would hit the US growth but would not push it into recession. There is a strong belief among the market analysts that looking at the continued disarray in the global financial markets and the resulting credit crunch, the Fed may ultimately resort to interest rate cut. All this leads to a conclusion that in the days to come, if there are more announcements of serious liquidity problems in major hedge funds or banks, which is, of course, not unlikely, the situation can turn into a full-blown global crisis warranting many adjustments and corrections from many quarters. 

Lessons for India
India has, of course, no direct connection to the US credit market, and yet its impact on the Indian stock market has been pretty severe: On August 16, the  Sensex lost 643 points in a single day’s trading falling to 14,358, and rupee crashed by 1.5%—the biggest fall of a day during the current fiscal. Some banks, such as ICICI Bank, State Bank of India and Bank of India are reported to have some exposure to the US subprime loan market in the form of collateralized debt obligations, credit default swaps and other derivative instruments, but it is said to be of no significance.

The real ‘take home’ from this episode for the Indian monetary authorities is: Indian  markets are no longer insulated from global happenings and, hence,  regulators must be quite vigilant and rigorous in their monitoring of the financial system. Any let-up in this regard is sure to make us highly vulnerable to the after-effects of such global mayhems. It also teaches us that monitoring the credit portfolios of banks—particularly, as Henry Paulson said, “When you have periods of benign markets, particularly in situations where parts of markets and the economy are growing at levels that are unsustainable, market participants aren’t going to be as vigilant as they should be”—is a must, for any let-up in this regard is sure to destabilize the very financial architecture of the country. Equally important is that banks, the ultimate lenders, have to exercise utmost prudence while originating loans and should not particularly get carried away by short-term gains.

Here, it is worth recalling what President Bush in his reaction to the correct subprime loan crisis said: “We’ve a lot of really hardworking Americans sign up for loans and, truth of the matter is, probably didn’t fully understand what they were signing up for.” The way in which the home loans portfolio of Indian banks has surged in the recent past makes one believe that the remarks of Bush are equally applicable to Indian home loan borrowers. And that is where monitoring of credit portfolios of banks by the RBI assumes greater significance. More so, when it is becoming increasingly clear that “monetary policy operates not only through the money channel but also through the credit channel.”

With the kind of financial deepening happening outside the helm of central banks, and the speed with which the integration of financial markets is progressing, the kind of control that they, as monetary authorities, could exercise is getting reduced. This warrants creation of new ways of controlling non-monetary components of liquidity in the financial system, and also use of such products which can send right and effective signals to the market about the central bank’s stance on monetary policy. Indeed, it is the ability of monetary authorities to communicate their policies to the public in clear and transparent way—which is said to be weak in emerging market economies—that decides the successes of their very monetary policy amidst such external threats, which have today became routine.

In the ultimate analysis, one wonders if a central bank can ever say what William Poole of the Federal Reserve Bank of St. Louis could say—“The punishment has been meted out to those who have done misdeeds and made bad judgments”—and wash off its hands. Or, should a central bank bail out the banks with necessary assistance such as injection of fresh liquidity as ECB Fed did? Economists, of course, disagree with such bailout of erring banks by central banks, for it results in moral hazard that can be a source for yet another bigger problem in the future. In their opinion, cut in interest rate such as what Fed did during LTCM crisis and now the cut in discount rate, is what creates moral hazard, and it is sure to encourage market-players to bet on one-side. Instead, they prefer penalizing those who mismanage their balance sheets. Ethical arguments aside, Indian economy is certainly not that big and robust enough to absorb such shocks, which means, it could only rely on prophylactic measures to keep its financial markets stable. This makes effective monitoring of both monetary and financial market a must. In today’s scenario, monetary authorities need to shift from their act of routinely scrutinizing the known variables to an act of anticipating the ‘unknowables’ and monitoring for their occurrence with suitable alternatives in hand to mitigate their adverse impact well before it becomes a storm throwing the market into complete disarray.

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