The Hindu Business Line : End of sub-prime loan consumption

For a long while now, the world had an upside view of economics. That is, consumption was seen as the driver of growth and debt to facilitate such consumption was consequently seen as a good thing. The good old economics of savings, investment and production as drivers of growth was relegated to the background and were viewed as subservient to the glory of consumption.

This had lead to the rather extreme situation in which vendor financing (i.e., lending of money by producers to consumers for purchasing products they produce) of the US by the developing nations was seen as a necessary business practice.

That story is now coming to an end. We have seen the end of sub-prime housing as lenders have woken up to the fact that the collateral underneath the loan is nowhere the value of the loan. Remember, it is not the sub-prime consumers who have stopped taking these loans, but the lenders who have wised up to reality, though belatedly, as a lot of banks are realising. This is going to ensure that this business segment is going to entirely disappear or at the very least, the lending standards are going to cover the substantial risk of defaults.

I have written about the US housing bubble for quite sometime now and often times I wonder how people are even surprised at the unwinding of the bubble. After all, very little of what was going on made business sense and like previous bubbles this one also had to end.

Unfortunately, for the US consumer, a few other long-standing bubbles will burst along with it. In the months ahead, three other categories await a similar fate — that is, housing (all categories — prime, Alt-A, interest only, etc.), auto loans and credit cards.

Even the most die-hard real-estate bulls now acknowledge that housing prices are in a downward trend for the forthcoming future. What they, however, still refuse to acknowledge is the enormity of the bubble and hence the consequent lengthy correction that awaits US housing.

As explained in my previous articles (http://financial-musings.blogspot.com), real-estate prices on the average tripled in the US over the last 10 years, facilitated by the bubble lending conditions and, hence, the post-bubble correction would have to match the rise (typically in a correction, the pendulum swings well past the median). On the average, we could expect at least another 30-40 per cent correction in US housing prices over the next few years.

So why would any lender want to give money for a collateral that loses market value, thereby ensuring that the purchaser’s equity stays negative due to falling prices? Just as rising prices made purchasing more affordable (due to an increasing share of owner’s equity, as indicated by the “paper worth” of the collateral), falling prices are, ironically, going to make it more expensive to own houses.

Lenders now have to factor a new risk into the equation — that is, due to negative equity the purchaser could walk out of the deal without losing anything, leading to foreclosure. So, this business of lending to all types of consumers for housing is set to fall dramatically in the months ahead.

Auto Loans, Skidding

For the last several years, it has been customary to allow consumers to trade in their old cars and roll the negative equity into a new car loan. These “E-Z” financing terms helped the purchaser to stay on course as far as their current debts were concerned and for the seller, allowed the movement of bulging inventories. In the last couple of years, consumers even were pre-paying some of their auto loans as they were able to extract even lower-cost and tax-deductible home equity to pay off some of the auto loans.

Due to the low defaults over the last few years, these auto asset-backed securities (ABS) were granted a “AAA” (readers would do well to remember that sub-prime mortgage backed securities were “AAA” rated in early 2007 and as of today, they are not even tradable) by the rating agencies allowing Wall Street to package and sell these to foreign investors.

This is very similar to housing, in general, and sub-prime housing in particular, the collateral underlying these loans were completely suspect and in any case, worth far less than the value of the loans.

With a rise in delinquency rates of auto loans as reported by GMAC and other auto loan companies in the last few months, the quality of ABS is now coming under greater scrutiny. The defaults in auto loans are going to accelerate in the months ahead and this is certain to raise question marks over the credit-rating behind these securities.

Once the investors understand that these ABS are pretty much “sub-prime”, they would want to exit causing a situation similar to what we have witnessed in the sub-prime housing segment. And similar to housing sales grinding to a halt, we are going to witness a steep slump in the auto sales as well in the months ahead.

Losing credit

The situation in the credit card segment was very similar to the auto-loans. Due to the low defaults facilitated largely by the mechanism of home re-financing, banks aggressively pursued new customers allowing them to rollover their existing loan into a short-term zero-interest facility.

And when this term expired, customers always were able to find another bank that was willing to extend a similar term for a new teaser period.

A rising default rate in the months ahead is going to cause a downgrade of the bonds backed by credit card debt. As explained, a host of conditions had temporarily caused a mis-pricing of risk by the lenders and those factors are now set to evaporate.

The biggest losers are going to be the lenders, i.e., the holders of these debt instruments, who either will not be fully paid back or, if Helicopter Ben takes over, will be paid back in dollars that would be massively debased. In real terms, these lenders are going to receive a lot less than what they had originally lent.

A legitimate right

What does all this mean for the US consumer in the longer term? Reduced consumption is an obvious consequence. But the more fundamental lesson is the fact every nation has to pay for its imports using the traditional route of exports.

For quite some time now, the US consumer has got away by paying for imports through pieces of IOUs — that is, the dollar. The sub-prime debacle is the first sign that the holders of these IOUs have woken up. The sub-prime housing defaults are also likely to be the proverbial tip of the iceberg that sees the entire consumer credit industry dramatically reduce in size in the years ahead.

US consumers, Wall Street analysts and central bankers around the world would then recognise that consumption is a legitimate right earned as a consequence of production.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in)

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