What is a Sub-Prime loan?
‘Prime’ and ‘Sub-Prime’ are both used to define the credit rating of borrowers in U.S.While the term ‘Prime’ is reserved for borrowers with good credit rating based on their track record, the term ‘Sub-Prime’ is used to describe borrowers with below par track records. This segment generally contains the poorer and younger population.
A ‘Sub-Prime’ loan is a loan catering to the latter segment of people.
Why were the loans disbursed?
The housing prices in the US more than doubled in 2007 since the year 1997. This incentivised the loan disbursement by the banks to the Sub-Prime creditors on the logic that the lenders would be able to pay the money back due to increase in property value. This allowed people with below par credit ratings to access loans which would never have been given to them by common financial logics of following the credit ratings. The federal government too did not interfere as it saw an opportunity where even the poor and the young could own homes.Ideally these loans would have gone only till the time the liquidity was sapped from the system. With stock markets on historic highs and the whole economic system bubbling with excess cash, many hedge funds and mutual funds saw an attractive opportunity in the form of Sub-Prime loan portfolios. This way the Sub-Prime lenders were provided with fresh funds to lend to the Sub Prime creditors and the cycle continued.
What went wrong?
These Sub-Prime loans have been devised for creditors with poor financial track records and below par credit ratings. This made the lenders charge a higher rate of interest compared to the Prime category of loans. This in turn cascaded to higher EMIs for the loans. This increased the risk on the portfolios as the people who were lent the loans already were not so strong financially and these increased EMIs put the repayments to risk. With so much liquidity flushed into the system the federal government did nothing to control the liquidity or to remind the lenders of financial prudence. More and more complex products were devised by the lenders defying all the logics.This continued on till the housing bubble busted in 2007-08. Primary reason was that the housing supply surpassing the demand. The house prices started falling. The Sub-Prime borrowers started to default on their payments as with already stretched finances they did not want to pay for the house which was falling in value.
Since the collateral for all such loans was the house itself, all such defaults lead to more and more houses being put up for sale and hence the supply increasing even more and thus the further drop in prices. This constituted a sort of vicious cycle. There are pockets of houses where the prices dropped almost 50 percent of their peak. This decline in housing prices made the matters worse for the lenders who now had the collateral valued less than the loan lent. This prompted a majority of mortgage players to book losses.
Complexities of the products
One major reason behind the crisis was the unwarranted complexities in the financial products being traded in the mortgage market. Firstly, the first hand lenders securitised the mortgages (loan portfolios). These Mortgage Backed Securities (MBS) were sold to other market participants and they sold it further to other players and so on.This is one of the reason why none of the players knew how much toxic assets they carry and the situation remains so until the dust settles down. This is also the reason why financial corporations like Citibank and AIG even with all the financial powers could not forecast the amount of hit they are going to take as the scenario becomes a bit clearer. This not only did affect the ignorant lenders but also the more prudent ones like Freddie Mac and Fannie Mae. These two mortgage giants did not disbursed the loans ignoring the credit ratings but when the mortgage market went bust they also received heavy jolts and booked losses in excess of $12 billion and had to be nationalised.
Impacts of the crisis
What followed was the slowing of U.S. economy with a huge vacuum created in the credit markets. The credit markets went dry as the banks did not have enough to lend. This hampered the credit raising ability of many corporations which included manufacturing firms like GM, Chrysler. Hence these corporations already battling it out in a slow U.S. economy further suffered the brunt of credit squeeze hampering their day to day operations.The banks did not trust the toxic exposure of other banks and this prompted them not to lend each other. This draught in intra bank lending escalated the credit crunch and led to further distrust on the balance sheet of other banks.
Also what followed was the increased number of defaults and foreclosures hurting the already weak economy. Not only the lenders but the corporations providing Insurance to these toxic assets were also hit hard. Insurance giants like AIG and Ambac who provided CDS (Credit default swaps) to these toxic assets thus ensuring that in case of any default they will insure the securities. With increased number of defaults they also bled as they initially did not lay stress on the quality of MBS they are insuring under the CDS.
Global banks and corporations had to write down the debts with largest hit taken by Citibank and Merrill Lynch in U.S. and UBS AG in Europe. However the hit on Asian institutions was limited one with Bank of China writing down the maximum of $2 bn. However many big shadow financial institutions like Bear Stearns, Merrill Lynch and Lehman Brothers filed for bankruptcy. Bear Stearns was brought by J.P. Morgan chase while Merrill by BoA. The collapse of AIG was avoided by the Fed by providing a bridge loan to it and thus avoiding the collapse of complete financial structure.
The total economic impact due to these MBS are difficult to calculate as still the picture is unclear about who is holding how much toxic an asset. Between January 1, 2008 and October 11, 2008 only the losses by U.S. corporations amounted to about $8 trillion as the assets in hands of different corporations reduced to $12 trillion from a high of $20 trillion. But this was just the tip of the iceberg.
At a global perspective this crisis threatened the countries with large reserves like Japan, China who invested quite a huge amount of money in U.S. securities.
Other important factors
Though the factors mentioned above may be the immediate contributing factors there are other long term factors too which should be taken into consideration. The increase in real wages in U.S. was 75 percent from 1950 to 1975. So the extra goods produced by the U.S. were consumed without any problems and hence the U.S. economy grew.This increase in real wages stagnated from 1970 to 2005 and grew at 2 percent in this period. Also the reduction in amount of work per week by an average U.S. worker decreased and thus the average weekly wages of an average U.S. worker has been on decline.
On the other hand the productivity has improved more than 70 percent in last 30 years. Thus out of total increase in profit which would be more than 70 percent only 2 percent was diverted in labour wages while the rest was parked with corporations. So the increase in production could only be consumed by population by borrowing from banks. The bank-corporation nexus emerged and with the money parked in the banks these banks grew phenomenally.
The average population in the mean time carried on consuming the products but with fewer incomes they had to borrow more on mortgage. At one time the ownership of homes decreased from around 70 percent to less than 50 percent as mortgages rose. Also the housing market emerged stronger as the consumption was linked to this housing market and so the demand for more homes by citizens of all background rose. Since demand kept on increasing the home equity also kept rising and as the house was collateral and it decided the amount of loan lent to a person so a housing boom was created.
Till now the mortgages rested with the banks that through their subsidiaries shed these toxic assets to their investment arm or shadow financial institutions like Investment banks and hedge funds in the form of MBS (Mortgage Backed Securities). Thus as the bubble was being created these securities were being sold to almost every institution having a financial exposure.
Since the wages were stagnant, the U.S. citizens could not sustain consumption. This cut down on consumption cascaded to fall in demand for houses. As the demand dipped, the home equity too fell sharply. Shadow financial institutions tried to sell these securities but there was no security left it was a junk toxic asset. This further declined the home equity and this made people default on mortgages. These things worked in a vicious cycle. People were unable to roll over their debt as the home equity fell and thus foreclosures made their way. This created the ruckus in financial markets. Also hit hard were the insurance companies who with CDS instruments insured these toxic assets.
Another factor which was primary to this crisis was the Current Account Deficit which U.S. ran in recent years. Defying the traditional logic which says the rich country would be in surplus and poor country in deficit did not hold true for U.S. The east asian economies after the 1997 debacle built up the current account surpluses through many factors including undervaluing the currency. This factor is much pronounced in the U.S. trade partnership with China. The heavily undervalued Rimnibi made sure that China runs heavy current account surpluses over U.S. This made U.S. to borrow more thus, increasing the liquidity in the market. Also countries with huge reserves like China and Japan also invested there surplus money into U.S. securities thus increasing the liquidity of the U.S. markets. This prompted the corporations to lend recklessly ignoring the financial prudence.
Another factor was the emergence of neo-liberals in the U.S. economy who have always demanded the markets to rule themselves and decide what is good for them. This has reduced the role of an agency like the Federal Bank who could have stopped such an escalation of reckless lending and complicating the financial products.
Indian perspective
Looking at this crisis with an Indian Perspective the exposure to these toxic wastes was not huge. It was more of a crisis of trust among the banks which culminated in the credit crunch. India which was more concerned with the problem of inflation which was hovering at above 10 percent level suddenly had to balance a scenario with credit squeeze and inflation at sub zero levels. Rising CRR and other benchmark rates which were a trend in India during late 2007 and early 2008 to soak excess liquidity had to suddenly brought down to ease of the credit squeeze.Though India was more or less robust during the whole crisis there were some chinks in the regulatory armour which did lead to some impact on some sectors.
The hugely hit sector was exports sector which according to some estimates has laid off more than 1million people especially in export hubs in Gujarat and Tamil Nadu. The Government did act but too late too little was done with these sectors as they were grappling with fall in demand in U.S. and European markets.
The IT sector which also saw some rough whether due to bankruptcy of many important clients and fall in demand for existing customers had to resort to cost cutting measures to maintain a healthy bottom line since the top line was either stagnant or declining.
The revelation however was the rural economy which proved to be a boon for India in these tough times. The rural India or Bharat as it is being referred to in many columns kept on consuming because of many reasons among which the farm loan waiver scheme and record monsoon in 2008 were the main reasons. This consumption was clearly visible in FMCG results as well.
Other long term factor which saved Indian economy was a savings driven structure contrary to the consumption driven structure of the west.
Though India was robust it was hit in two channels i.e. Consumption channel and Investment channel. After the record FII in 2007 it was the bears that rose to the occasion and with heavy action in U.S. many prominent players packed up their holdings and went home. Also in consumption channel the real estate which was rising steadily in India fell down and exposed the weak structures of Indian reality firms.
Role of RBI
Unlike many central banks across the globe RBI perhaps was the only one which held up its cards till last moment and though it did tried to ease of the money supply it never went emotional to decrease the rates to a sub 1 percent level as was seen across the globe.The main reason being the 12 percent inflation which the RBI was fighting before the recession swept past India. It knew that once the economy bounced back it will again have to handle inflationary pressures on the economy. What also comforted RBI was the meagre exposure to toxic assets for Indian banks and the strong Public banks balance sheets.
RBI reduced the CRR by 50 basis points to 5 percent in January 2009. This infused the liquidity to the amount of Rs. 20,000 Cr into the system. Now the banks had to park only 5 percent of the amount with RBI and the rest could be used to lend and thus increasing the liquidity.
RBI also reduced the repo rate and reverse repo rate by 100 percent to 5.5 percent and 4 percent at the same time, thus de-incentivising the parking of bank funds with RBI. This means that RBI would charge less on the funds borrowed from it thus asking banks to increase lending and also the reverse repo rate decrease paid less interest over the amount parked with the central bank thus asking the lenders to use it to lend to private consumers.
Though this was done with good intentions the private lending did not pick up as private banks still were hesitant to lend. Another effort was made on April 22nd 2009 when RBI brought in a second rate cut which made Repo and Reverse Repo at 4.75 and 3.5 percent respectively.
Since September 2008 RBI has reduced the Repo and Reverse Repo by 425 and 325 basis points in an attempt to boost up the liquidity and private lending. But with inflationary pressures again mounting over the economy with Oil rising up and commodities becoming hot again it is to be seen how much time the RBI takes before it raises the rates again.
Though India showed its robust economy to the world during this recession it would be rather cruel to say it did brought some positives for India. If not for recession Satyam fiasco would have been covered up. Also the strengths of Indian public banks were appreciated by the world as by the Indian aam adami. The faith in savings based structure was restored and a more efficient RBI showcased its efficient policy making. The rush of deposits in national banks helped them lend to the needy sectors like education and infrastructure. Though the crisis is not over yet but the worst certainly seems to have passed.
APPENDIX
RBI – Reserve Bank of India
CRR – Cash Reserve Ratio
FMCG – Fast Moving Consumer Goods
FII – Foreign Indirect Investment
MBS – Mortgage Backed Securities
CDS – Credit Default Swap
ACKNOWLEDGEMENT
www.rbi.org
The Economic Times
www.forbes.com
www.wikipedia.com
RBI – Reserve Bank of India
CRR – Cash Reserve Ratio
FMCG – Fast Moving Consumer Goods
FII – Foreign Indirect Investment
MBS – Mortgage Backed Securities
CDS – Credit Default Swap
ACKNOWLEDGEMENT
www.rbi.org
The Economic Times
www.forbes.com
www.wikipedia.com
