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The why's and how's of subprime...

Oct 8, 2008

Greed and recklessness describe the entire subprime debacle. The US mortgage market was estimated at US$ 12 trillion with approximately 9.2% of loans either delinquent or in foreclosure through August and September 2008. According to Wikipedia, sub prime loans represented only 6.8% of the loans outstanding in the US at the end of FY08. Yet they formed 43.0% of the foreclosures. The crisis saw the end of investment banks in the US and followed a series of bailouts and buyouts. The final one being the US$ 700 bn package proposed by the US Treasury to stimulate economic growth and inspire confidence in the financial markets. In this article we take a retrospect at what led to the evolution of this crisis and the learnings there from.How it all started...
Sharp slowdown in economic growth, decline in consumer spending and consumer confidence, falling corporate profits, slowdown in capital investment, declining production in the manufacturing sector and a wave of job cuts at the end of 2000 prompted the Fed to cut interest rates. US economic growth in the fourth quarter of 2000 declined to 2.2%, a four-year low. As per the National Association of Purchasing Management, a steep decline in manufacturing activity in December 2000 suggested that the overall economy was growing at a rate of less than 1% a year. Declining auto and retail volumes and increasing layoffs indicated that US economy was slipping into a recession. In 2001, after the 9/11 terrorist attack, the situation only worsened.

To curb the fears of recession, the Federal Reserve since 2001 followed the policy of setting interest rates at lowest levels and real interest rates at negative levels. This easy money policy was to increase the consumption demand to keep the economy growing. This in turn gave rise to a platform for cheap and easy loans. People used this as an opportunity to take home loans to buy property. The overall US home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2% (source: Wikipedia). Since demand far exceeded supply, the real estate prices started to rise. The personal debt levels also witnessed an increase. US household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade. Higher demand paved way for higher inflation, which prompted the Fed to increase interest rates.

Particulars1997
(As a % of Financial Sector Assets)
2007
(As a % of Financial sector assets)
US Banks56.3% 23.7%
Pension funds and MF's 21.0%37.8%
Source: Bloomberg

While this was on the demand side, on the supply side the banks were the culprits. With mutual funds and pension funds playing the role of custodian of savings and deposits, banks in the US were forced to look at newer roles. Bankers saw lower interest rates as an opportunity for higher risk taking. They started to give out home loans to even those who would not have got home loans in the normal scheme of things. This market came to be known as the sub prime market. The average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 % points in 2001, to 1.3% points in 2007. From being mortgage holders, banks changed their focus to collect loans, which were then sold, to the investment banks and others, earning them fees in the process. In this greed of fees, the banks ignored the quality of the borrowers. As per Wikipedia, an estimated 8.8 m homeowners - nearly 10.8% of total homeowners had zero or negative equity as of March 2008, meaning their homes were worth less than their mortgage. The poor loans were further sliced and diced into many tranches and sold to hedge funds and investment banks. With house prices expected to continue going upwards, the sub prime lending bubble only increased in size and deteriorated in quality. The primary culprit of the sub prime crisis was not the housing bubble, but the widespread assumption that the bubble will never burst.

How the tide turned...
With Fed raising the interest rates to a high of 5.25%, the refinancing ability of the borrowers were put at stake on account of increasing mortgage payments. This led to the turnaround in the housing market resulting in rising foreclosures and falling housing prices. The price decline in May 2008 was 15.8% YoY. As the housing prices fell, the exotic financial instruments lost their value. With increasing redemption pressure, the hedge funds and investment banks faced the dual problem of rising defaults and losses / write offs of their assets.

The problem of plenty suddenly turned into a problem of survival. The credit, which was available in plenty at cheap rates, was now difficult to avail. On account of uncertainties, the situation in credit market got worse. Hence the Fed once again had to step in. For a faster expansion of money supply it reduced the Federal funds rate from 5.25% to 2.0%. Thus the vicious cycle continued. The state of the financial markets currently are grim, and if funding pressures continue, there is an increasing danger of a prolonged global recession.

Lessons learnt?

  1. Greed, unwarranted risk taking and unreasonable leverage can bring down even a multi trillion dollar economy.

  2. Speculative practices and poor governance of large organisations (assumed to be Too Big To Fail) can lead to the demise of sectors and companies that have evolved over decades.

  3. An unaccountable top management that does not share the downside risks associated with the company is a sure recipe for failure.

While these may be the key learnings from the crisis so far there are many more that are being learnt each day in different parts of the world as the catastrophe unfolds. What is important is how long we retain such learnings in our memories.

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