Fenil's Library

sub-prime wasn't all wall st's doing

lax regulation and govt intervention was as much to blame

vivek kaul. mumbai

we stepped out of the coffee shop into a hot and humid day. but my friend wasn't done with her questions yet.

"i still haven't figured one thing out," she said.

"now what?" i asked. "i thought we were done for the day."

"banks going bust isn't new. it's been happening over the last three hundred years. even in india, i hear of cooperative banks going bust all the time. but that does not create a crisis across the world?"

"interesting question. try reading the latest issue of the economist and you will have all the answers."

"i don't have the patience to do that and i don't think i will understand. so why don't you tell me," she said, with a smile hard to tear away from. the coffee shop was some way behind us and the best we could do was walk the talk, looking for that elusive shade that had room for two.

"well, we discussed how a low interest rate environment in the us led the banks there to give out home loans to sub-prime borrowers or individuals who were not creditworthy," i said as we walked. "the banks passed on the risk through issue of financial securities, eventually sold to investors across the world. the banks got their money back upfront and when the borrower paid the equated monthly instalment (emi), a major part was passed on to the investors who had bought these financial securities. now, the sub-prime borrowers had taken loans primarily because of the low emi structure. with housing prices on their way up, these borrowers planned to sell out before the higher emis set in. but when they tried to sell out, there were not enough buyers because the prices had run just too far. at this point, sub-prime borrowers started to default. and banks and financial institutions who had bought these securities were in trouble."

"but why would banks and financial institutions across the world were in trouble," she asked.

"oh. banks and financial institutions from all over the world, particularly europe, had bought these sub-prime financial securities. so once sub-prime borrowers defaulted, all these financial institutions were in trouble."

"but didn't these financial institutions know the securities were risky?"

"well. banks and financial institutions do try and figure out the risk before investing in an asset and typically look at credit ratings. but, as things stood, the sub-prime securities had been given good ratings by the rating agencies, predictably led by the incentives paid by the issuing institutions."

"ah, i think i get you now. once the sub-prime borrowers started to default, the credit rating did not really matter. since banks and financial institutions from across the world had invested in these securities, the crisis spread far and wide. earlier, once a bank went bust, the impact was limited to the local economy and area. now, because of securitisation, the crisis spread far and wide," she replied.

"i always knew you were a smart girl," i said.

"but was there any other reason for expansion of sub-prime loans and financial securities?"

"yes. the us government wanted to encourage affordable housing. in order to do that it encouraged state-sponsored enterprises fannie mae and freddie mac to buy sub-prime financial securities. once fannie mae and freddie mac started buying a lot of sub-prime securities, the market for sub-prime home loans expanded. banks and financial institutions caught on and started making more sub-prime loans, thus expanding the market. once they had given out the loans, they securitised it and issued financial securities, which were bought out by the likes of fannie mae, freddie mac, wall street firms and european banks. securitisation ensured that they got their money back immediately and hence could go out and make more sub-prime loans. and so the loop worked," i explained.

"but weren't fannie mae and freddie mac also bailed out by the us government?"

"you are right. once sub-prime borrowers started to default, fannie and freddie were in trouble because they had invested a lot of money in sub-prime securities. the us department of treasury bailed the two agencies out by giving them $100 billion each, so they may continue to provide liquidity to securitised financial securities."

"are you suggesting the wall street alone was not responsible for this mess?"

"that's precisely the point i am trying to make. there was a lot of regulatory oversight as well. many independent home loan brokers who did not come under the regulatory supervision of the us fed made some of the riskiest loans. the low-interest regime followed by the us fed from mid-2003 to 2006 led to the housing bubble, which led to more and more people taking on loans much beyond their repayment capacity in the hope of making a quick buck. also, as in india, home loan borrowers in the us are allowed to deduct the interest paid by them on their home loans from their taxable income. this too led to people speculating on the housing market."

"what a mess. but, how do you know so much yaar?"

"oh, like i told you, the economist had it all."

"hmmm. one last question. i have been hearing a lot about credit default swaps and how there could be a bigger problem there. can you explain that?"

"not today please, but may be tomorrow."

"done. the coffee's on me."

 

(the example is hypothetical)k_vivek@dnaindia.net