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Sub-prime accountability issues to the fore

Merrill Lynch headquarters in New York City.

The never ending crises in the U.S. sub-prime housing market and in the broader credit market have started taking their toll. As major banks involved in the transactions started taking big hits by way of loan loss provisions and write-offs, the clamour for accountability has been growing louder.

On November 4, Citibank Chairman and CEO Charles Prince announced his resignation taking responsibility for the bank’s spiralling losses. His resignation came soon after the announcement of a write-off of up to $11 billion in sub-prime mortgage losses in the latest quarter over and above the $6.5 billion in the previous quarter.

The departure of the Citibank CEO follows the resignation, just a week earlier, of Stan O’ Neal, the head of Merrill Lynch, one of the world’s best known investment banks. Like Citi, Merrill Lynch too is said to be neck-deep in the sub-prime loans business. More heads are expected to roll; according to reports, very few banks in the highest league had stayed clear or minimised their exposure to the sub-prime loans business.

The risks in the business should have been apparent. In India, ‘sub-prime’ has a different meaning. It refers to the practice of top corporates taking loans from banks at below their prime lending rates. Obviously, only those with plenty of clout can force the banks into lending at very attractive interest rates. In the U.S., sub-prime loans are those lent to borrowers with poor credit records. These are by definition risky loans, the risk element exacerbated by the fact that the less worthy borrowers have to pay more for their borrowing.

The reasons why many of the top names plunged headlong into an inherently risky business are interesting and have meanings for India too. In an era of abundant liquidity and intense competition, banks canvas aggressively for business that they would shun in more normal times. The relentless drive to book profits and please the shareholders and hence take risky bets has been another motivating factor though, of course, this one is by no means peculiar to the banking business in the U.S. or anywhere else.

When the U.S. housing market was rising, sub-prime loans to those buying homes often seemed to be good business. After all the value of the home mortgaged to the lender kept rising. This had two implications. The lender’s security became better. Second, the borrower had access to ‘home equity’. Take additional loan on the enhanced value of the property. Commonsense suggests that the borrower, risky to begin with, is dragged further into debt. When the home market collapsed, the lenders did not even have the original security cover. Foreclosures and distressed sales have become common. Because of their negative implications for the macro economy, the U.S. government is actively involved in monitoring the crises.

There is another reason why the practice of dispensing loans became so widespread.

The original lenders securitised their loans and sold them in parcels as mortgage based securities. Further complexity was introduced when pools were formed out of these and other securities with different degrees of risks. Called collateralised debt obligations (CDOs) these opaque instruments have entered the banking lexicon with a doubtful reputation.

But while banks such as Citi have led a wave of innovations, devising CDOs and other not easily understood instruments, one important advantage perceived by the original lender was that he did not have to hold the loans in his books.

It is for this very reason that the risk assessment might have become that much lax: after all a default will not harm them except in a roundabout way and even here will affect their reputations more than their balance sheets. For Citi and many others however the experience was different.. They were left holding billions of dollars of such paper. When there is ample liquidity, banks are prone to be lax in assessing risks. Besides, most of these instruments enjoyed investment grade ratings. The part played by the rating agencies in the latest crisis is being probed further.

There can be no two arguments that the financial instruments and the techniques employed to devise them are so complex that not just the investors, but the rating agencies, the regulators and on occasion their creators themselves did not comprehend the risks. Accountability, highlighted by the exit of CEOs in the U.S. after being held responsible for the mess, is one of the several issues that will be relevant for India. The growing complexity in the financial services industry is another.

Practically all banks are positioning themselves as financial supermarkets offering all kinds of products and services.

Certainly most of them are not adept at all these. For instance, selling a long period insurance product is different from the more traditional function of opening a term deposit. The ongoing crises in the U.S. will have many more messages for India.

C. R. L. NARASIMHAN

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