The Hindu Business Line : Pains from the sub-prime fiasco

With the increasing role of Sovereign Wealth Funds, China, Japan and Singapore may soon insist on demanding better supervisory and monetary management in disaster-prone countries, such as the US.

S. Venkitaramanan

The global markets have been witnessing a sudden volatility due to withdrawal of investible funds. This has been provoked by what the media call the sub-prime woes of the US housing mortgage market.

Encouraged by the low interest regime and high liquidity, thanks to inflows from Asia and other economies, US banks started lending liberally for housing. Their credit to sub-prime mortgages — loans below full creditworthy lenders — boome d because of the low interest regime and hefty promotional campaigns.

Sub-prime borrowers were riskier but paid higher rates. Lenders started relaxing lending conditions, such as full documentation for sub-prime borrowers. No documentation loans could get about 70 per cent of the value of the property.

Counting on the rating

The expansion of US housing loans would itself have not been so disastrous if it were not fed mostly by investors from Wall Street firms buying securitisation bonds — made up of accumulation of such loan assets.

These firms, attracted by higher returns on sub-prime loans, relied on rating of these bonds by rating agencies. The rating agencies were beguiled by the low default rate of sub-prime loans, which was partly due to rising house prices. Loans could be refinanced in such a situation.

The investor firms, including pension funds, invested because these bonds got an “A” rating from rating agencies. This was mandatorily required for such funds to invest. The lenders, however, went to extremes to make the loans attractive, such as making interest rate low for the first two years, raising it to acceptable levels for the next 28 years. This was too much of a risk for lenders to take, for in the event of interest rate tightening, the borrowers would be caught. The lenders also innovated with adjustable rate mortgages, a sure recipe that could hurt the borrower in a regime of rising interest rates, following a benign rate regime. These innovations were regarded by experts at the time as good as they spread risk from the lenders to the investor and the markets. The danger was that this distanced the borrower from ultimate provider of funds — the Wall Street firms and the hedge funds, — from the action, namely lending. The only saving grace (?) was rating by rating agencies, partly lulled by the prospect of fear.

The risk was great, but so was the return. The return attracted investors from New York to Sidney. In the galaxy of investors who swallowed the bait come distinguished banks in Australia, Singapore, Germany, besides Wall Street’s leading investment banks, such as Bear Stearns. The rating agencies dissuaded the fear of sub-prime loans having a high default rate. The investors extracted high returns on the collateralised debt obligations, as the securitisation scrips were called, but they did not materialise.

Vicious cycle unleashed

Investment banks, such as Bear Stearns, had to report heavy losses. Indeed, some hedge funds were wiped out. These collapses led to a shortage of investible funds both for the US stock markets as well as globally. This funds crunch, in turn, led to the fall of stock prices and a vicious cycle followed. Redemption pressures led to further suction of funds and stock market fall. Overall, the sub-prime bust had a disastrous effect on global stock markets.

In response to the crisis, the US Fed and the European Central Bank both pumped in additional funds to restore liquidity. This was a classic reaction on the model of Greenspan’s response to a crisis, first in the eighties, and later when the Asian crisis and the Russian meltdown happened.

It is worth noting that when an exercise was attempted by the German Government to rescue one of its lenders, which had burnt its fingers in the sub-prime fiasco, the US media was prompt in attacking such state intervention. But, it does not lie in the mouth of US opinion-makers to criticise state intervention in the case of widespread distress. After all, it was the US Government that set up the Resolution Trust Corporation to fund the losses of the failed Savings and Loans Associations in the 1980s. That Corporation incurred billions of dollars to cover up S&L losses. As it is, the US financial community is trying to play down the sub-prime losses, which have been widespread. But truth will finally force the US Government to intervene.

Wake-up call

The pity is that the so-called innovations and aggressive lending without adequate documentation and supervision of US lenders has caught the world investors in a bind.

This is perhaps a wake-up call to central bankers all over the world. Their total faith in rating agencies’ fiduciary responsibility may have to be reconsidered. This is particularly significant since in Basel-II, the central banker is laying much stress on rating agencies’ assessment of the quality of loans to determine their riskiness and capital adequacy. He should be careful.

The proneness of the US financial system to disasters of this kind also puts in question its much vaunted quality of US regulation and supervision. The blame game has started in full earnest. Fingers are being pointed at Mr Alan Greenspan for introducing a very low interest regime in the first instance and encouraging financial innovation based on it.

Mr Greenspan, however, recognises that it was a calculated risk, although he did not fully anticipate the present developments. But, he and his colleagues, of whom Mr Ben Bernanke is one, are of the view that the dispersion of risk from the lender to the investor is on the whole a desirable step. The low interest regime did lay the foundation for the growth of the US economy although it led to the development of risky lending practices. It is for Mr Bernanke to sort out the problem.

Reversal of roles

The list of sub-prime victims extends from the sublime to the ridiculous. Venerable institutions, such as Harvard and Yale, are reportedly included in the roll call of dishonour because they are tempted by the higher returns and the rating agencies’ grading. The risk of totally relying on rating agencies must be painfully obvious.

While individual investors, such as Harvard, may have lost their bit in the imbroglio, whole swathes of portfolios have lost in the fall of stock markets. No state action can compensate this. Perhaps, it is appropriate to remember that in a globalised market, we have to share the pains with the gains.

At the same time, with the increasing role of Sovereign Wealth Funds, there is a hope that China, Japan and Singapore may soon insist on demanding a better supervisory and monetary management in disaster-prone countries, such as the US.

That would be a consummation devoutly to be wished for — the erstwhile developing countries calling to book the wayward financial governance of the developed world, including Wall Street and the US Fed Reserve!

That would be a proper task for the new international source of investible funds — that is, composed of Sovereign Wealth Funds, such as owned by the Asian five — Japan, China, Singapore, Taiwan and India.

It would be interesting to watch the reactions of experts, such as those from Harvard and Yale, to such a turn of events. The pains of US sub-prime bust would have then been worth the while.

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