The Hindu Business Line : Sub-prime fallout: Beyond stock markets

The sub-prime lending storm did not break overnight. The clouds had been gathering strength for some months. Low interest rates and ample liquidity led to unbridled credit expansion, asset growth and proliferation of collateralised debt. The typical response from the markets was only to wish away the crisis.

The US housing loan market, involving trillions of dollars and many financial institutions and hedge funds, is very large. The markets adopted an ostrich-like attitude, fearing a cascading effect. Any efforts to contain the risks or tightening of credit would have meant triggering a crisis in the mortgage market.

There is no precise data on the depth and extent of the damage. It is estimated that 20 per cent of the total housing loans and about of 40 per cent of the assets acquired during 2006 are of sub-prime grade. A prominent merchant banker’s failure to market a collateralised debt paper and freezing of $2 billion by an international bank brought the problem to a boil. No avenues were left to offload the securities because of heightened fears about the quality of assets. Some investors reportedly lost up to 50 per cent of their investments.

Facing allegations of hiding the risks, international rating agencies are waging a damage-control war, assuring the markets that the risks are overstated. In the same breath, in a typical reaction of ‘bolting the stable door after the horses have fled’, the agencies are downgrading hundreds of billions of dollars of debt. There are analysts who differ and say that the risks are being understated!

Many banks, insurers and hedge funds have taken the hit but are tardy in coming into the open. A quick review by the German regulators drew response from IKB Deustche Industrie Bank, which replaced its CEO and expressed fears about its earnings. The credit squeeze created liquidity problems, aggravated by the fall of stock markets and redemption pressures on hedge funds, draining funds from the markets. The central banks of Japan, Europe and the US pumped in huge amounts to improve liquidity.

In fact, in such periods, funds usually flow to the banks, considered safe havens, improving liquidity. It is the reluctance to take a plunge into troubled waters that makes credit scarce. Customers with top ratings, who otherwise look to the markets, quickly renew their relations with bankers without much hassle. It is the average borrower who feels the pinch, both in terms of availability and price.

Impact on India

In a global environment, no market can insulate itself. Thanks to the regulation of overseas investments, not many banks or insurers seem to have been hit by the crisis. The Indian stock market bore the brunt as the FIIs withdrew.

This, apparently, is a passing phase and, as witnessed, the market did recover, aided by such steps as injection of liquidity and lowering of interest rates by the central bank.

Housing loans in India cannot be classified as prime or sub-prime in the absence of a proper credit-rating and pricing mechanism. Except a cursory check of the financials of an applicant and a quick look at the documents of title, no detailed appraisal is carried out. The introduction of centralised asset processing in some banks has diluted the scrutiny at the field level. Agencies such as the Credit Information Bureau of India can only ensure elimination of defaulters, as rating of individuals is still in a nascent stage.

Banks are free to fix the interest rates, but with a benchmark rate across the board, save for allowance for period and size of the loan, the concept of risk-based pricing is not practiced. An analysis of the NPAs in housing loans should throw up interesting features.

While liberal provisions can camouflage the true picture, the increased EMIs will result in a spurt in NPAs in the coming months.

Due to the hardened interest rates and fewer new approvals, the demand for housing has seen a slump and it might be difficult to enforce the securities.This may be paradoxical as, in normal times, a slowdown in housing starts should see an upward movement in demand and price.

Risk management

Prudence and risk-management dictate that investments too should be appraised with the same diligence as in the case of credit.

But with competition, scarcity of good paper, other than government securities, and very little time available for appraisal, decisions are based on the names of the issuers or marketers.

The way the debt instruments, backed by sub-prime lending, were gobbled up by international investors and hedge funds highlights this weakness in the system.

A meaningful and scientific asset liability management on an ongoing basis could help tide over liquidity and market risks.

Tightening of credit norms and streamlining of risk management measures should be on top of the agenda in any review of housing loan portfolios. Credit monitoring, credit risk-modelling, risk-based credit rating/pricing should not any more remain obligations to the regulators or confined to the corporate corridors but practised at all levels.

Operational risks too need attention in the context of Basel-II implementation.

(The author is a former managing director of State Bank of Mysore and can be contacted at: murthy@mandavilli.com)

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