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The saga of sub-prime mortgage muddle

— FILE PHOTO

BITTER HOME LOANS: A home is advertised for sale at a foreclosure auction in Pasadena, California, U.S., last month. The number of homeowners receiving foreclosure notices hit a record high during spring, driven up by problems with sub-prime mortgages.

“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.

Sub-prime loans are those given to borrowers whose creditworthiness is below prime and hence are of low quality. In India, sub-prime lending refers to loans carrying rates below the prime lending rate normally offered to high quality borrowers.

Sub-prime or low quality loans are mainly of three kinds: car loans, credit card loans and house mortgage loans. Of these, the biggest and the ones that can endanger the entire financial system are the house mortgage loans. These formed nearly one fifth of all U.S. mortgage loans in 2006, going up from 9 per cent till 2004.

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 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.

Typically, a bank or mortgage finance company (many of them owned by banks) lent to a sub-prime borrower to finance purchase of a house. Since the borrower did not have the means to even pay interest in the beginning, the lender sugar-coated the loan through an adjusted rate mortgage (ARM). One type of such a loan was called 2-28. During the first two years of a 30-year mortgage loan, interest was pegged at a low fixed rate of 4 per cent. In the subsequent 28 years, the rate was floating (variable) at around 5 per cent over a benchmark rate such as LIBOR (London Inter-Bank Offered Rate).

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. When the first two years expired, the interest rate also moved up to very high levels. With LIBOR ruling at over 5 per cent, the mortgage rate shot up to 10 per cent. Suddenly, the EMI (equated monthly installment) of such a loan nearly doubled: for a Rs. 5 lakh loan, it is Rs. 4,470 a month for a 28-year, 10 per cent loan, against Rs. 2,400 for a 30- year 4 per cent loan.

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 (collateralised 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.

These CDOs were bought by some big investment banks and hedge funds in which the super rich invested for high returns. They, in turn, financed these investments by borrowing from banks against the security of CDOs. The banks’ action in passing on the risk to others boomeranged, with the same sub - prime loans coming back to them as security for loans.

The whole arrangement crumbled when things turned adverse with falling home prices and rising interest rates. In early 2007, when New Century Financial, a large sub-prime lender, collapsed, it resulted in Barclays Bank taking over sub-prime loans of about $900 million. In February, HSBC, another big British bank, 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.

Authorities in Europe and the U.S. had to pump in money to prevent the whole system from collapsing. These developments had their impact on Indian stock markets in which many hedge funds and investment banks had invested. When they faced liquidity problems in the U.S., they sold part of their Indian holdings, sending the share indices down.

With the sub - prime loans taking different avatars and changing hands frequently, no one knows for sure which institution holds how much of the low quality loans. Assessing the impact of this worldwide financial contagion will take months, if not years. Perhaps, it could bring about a prolonged recession or very slow growth in the U.S., as it happened in Japan in the1990s.

Part of the blame perhaps attaches to the U.S. Federal Reserve which detected the problem too late to take corrective action.

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.

R. VISWANATHAN

(Retired Deputy Managing Director, State Bank of India)

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