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.
Image - courtesy: uk.dhtl.in
Image - courtesy: uk.dhtl.in
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