MacroScan - Lessons from the US Sub-prime Lending Crisis

A noticeable feature of growth dynamics in contemporary times is that investment and consumption spending by households has been an important stimulus to growth. Such spending, in turn, has been stimulated by changes in the financial sector that have increased the volume of credit, eased interest rates and made credit available to individuals and firms that would have earlier been considered inadequately creditworthy.

The last of these is of relevance, because it draws into the market for housing and non-essential consumption a set of consumers, who would not be present in these markets if their spending was determined by their current income. A credit boom expands the market for certain assets and commodities at a much faster rate than is possible if demand growth were dependent purely on either income growth or on changes in income distribution.

Needless to say, income growth does matter in the medium term, inasmuch as indebted households would have to earn the incomes to meet the interest and amortisation payments on their debt. If the requisite increases in income do not materialise, defaults multiply and this unwinds the boom. It would also have collateral effects because it impacts on financial agents left with non-performing debt and assets whose prices are falling because of excess supplies of confiscated assets on sale.

The US is an economy that now is experiencing such a downturn, the full consequences of which are still unclear. The housing market in the US has been crucial to sustaining growth in the US ever since the dotcom bust of 2000. Galloping housing purchases stimulated residential investment and rising housing asset values encouraged a consumption splurge, keeping aggregate investment and consumption growing.

As Chart 1, which provides the quarter-wise annual rate of change in the combined US House Price Index shows, the housing market began experiencing a boom in the middle of 2003, which peaked in mid-2005. Though housing prices have continued to rise since then, the annual rate of inflation has consistently declined (Chart 2). This in itself may be a much needed correction that should be welcome.

But the downturn is giving cause for concern for two reasons. First, as mentioned earlier, growth in the US economy has been sustained by the boom in housing. Rising house values increases the wealth of home owners and has a wealth effect that encourages debt-financed consumption. This drives demand and growth. The housing boom also pushes up residential investment and construction which through the demands it generates and the employment it creates helps accelerate growth. As Chart 3 shows, these features seem to have played a role during the current housing cycle as well, though the effect is more noticeable in the case of residential investment than consumption, where other factors too must have played a role.

The second problem lies in the way in which the boom was triggered and kept going. Housing demand grew rapidly because of easy access to credit, with even borrowers with low creditworthiness scores, who would otherwise be considered incapable of servicing debt, being drawn into the credit net. These sub-prime borrowers were offered credit at higher rates of interest, which were sweetened by special treatment and unusual financing arrangements-little documentation or mere selfcertification of income, no or little down payment, extended repayment periods and structured payment schedules involving low interest rates in the initial phases which were "adjustable" and move sharply upwards when they are "reset" to reflect premia on market interest rates. All of these encouraged or even tempted high-risk borrowers to take on loans they could ill afford, either because they had not fully understood the repayment burden they were taking on or because they chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming.
Chart 1 >>

The default risk which was almost inevitable in this kind of lending, increased sharply when interest rates rose. The net result has been an increase in defaults and foreclosures. The Mortgage Bankers Association has reportedly estimated aggregate housing loan default at around 5 per cent of the total in the last quarter of 2006, and defaults on high-risk sub-prime loans at as much as 14.5 per cent. With a rise in so-called "delinquency rates", foreclosed homes are now coming onto the market for sale, threatening a situation of excess supply that could turn decelerating house-price inflation into a deflation or decline in prices. The prospect of such a turn are strong given estimates by firms like Lehman Brothers that mortgage defaults could total anywhere between $225 billion and $300 billion during 2007 and 2008.

The first casualties in the crisis have been the mortgage lenders, who used borrowed capital to finance mortgage lending. Firms like New Century Financial, WMC Mortgage and others, which made huge returns during the boom, expanded lending volumes, encouraged by low interest rates and slowing house price inflation in 2006. This required moving into the sub-prime market to find new borrowers. Estimates vary, but according to one by Inside Mortgage Finance quoted by the New York Times, sub-prime loans touched $600 billion in 2006 or 20 per cent of the total as compared with just 5 per cent in 2001. These mortgages reflected very little own equity of the borrower. According to Bank of America Securities, loans to sub-prime borrowers in 2001 covered on average 48 per cent of the value of the underlying property. This had risen to 82 per cent by 2006. According to the Financial Times, more than a third of sub-prime loans in 2006 were for the full value of the property.
Chart 2 >>

Mortgage lenders or brokers were encouraged to do this because they could easily sell their mortgages to banks and the investment banks in Wall Street to finance their activity and make a neat profit. And the investment banks themselves were keen to buy into the business because of the huge profits that could be made by "securitising" these mortgages. Firms such as Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, Deutsche Bank, UBS and others bought into mortgages, pooled them, packaged them into securities and sold them for huge fees and commissions. Numbers released by the Bond Market Association indicate that mortgaged backed securities issued in 2003 were at a peak in 2003 when they totalled $3 trillion. Even though total values have declined since then because of the deceleration in home price inflation, they are still close to the $2 trillion mark. Among the investors in these collateralised debt obligations (CDOs) are European pension fund and Asian institutional investors.
Chart 3 >>

With high returns on creating these products and facilitating trade in them, the investment banks were hardly concerned with due diligence about the underlying risk associated with these securities. That risk mattered little to them since they were transferred to the purchasers of those securities. The risks in the final analysis are shared with pension funds and institutional investors which were buying into these securities, looking for high returns in an environment of low interest rates. They are now experiencing a sharp fall in their asset values and threatened with losses.

In fact the process of securitisation involves many layers. To quote the Financial Times, the original mortgages are "sold by specialist mortgage lenders on to new investors, such as Wall Street banks, who then use these to issue bonds which are often then repackaged again as derivatives." According to that paper, data from the Securities Industry and Financial Markets Association indicate that more than $2 trillion of mortgage-backed bonds were sold last year, of which about a quarter were linked to sub-prime mortgages. In sum, this whole process, which has at the bottom home owners faced with foreclosure, is driven by layers of financial interests looking for quick profits or high returns. This has transformed the mortgage securities business. In earlier times, these securities were bought by investors who held them till the loans matured and earned their returns over time. Now these are marked to market and traded. They are also use to create complex derivatives which too are marked to market and traded.

The net result is that the housing market crisis threatens to build into a crisis of sorts in the US financial sector, resulting in a liquidity crunch that can aggravate the slowdown and precipitate a recession. All this has occurred also because of the regulatory forbearance that has characterised the ostensibly "transparent" but actually opaque markets that are typical of modern finance. Investment banks did not reveal the weak credit base on which the mortgage securities business was built, investment analysts routinely issued reports assuaging fears of a meltdown, credit rating agencies did not downgrade dicey bonds soon enough, and the market regulators chose to look the other way when the speculative spiral was built.

But now that the crisis has struck, fingers are being pointed at others by every segment of the business. The first fall-person has been the ostensibly deceitful home owner. "Liar-loans" in which the borrower does not truthfully declare incomes is blamed by the business for its crisis. But it takes little to prevent such activity, if lenders actually want to. The Mortgage Asset Research Institute, found from an analysis of 100 loans involving self-declared incomes that documents those borrowers had filed with the IRS showed that 60 per cent of them had inflated their incomes by more than half. It doesn’t take much to demand an IRS return when making a loan.

The investment banks are of course blaming the mortgage lenders. Wall Street banks are filing suits to force mortgage lenders to repurchase loans which they claim were sold to them based on misleading information. If a Wall Street bank can be tricked, they don’t have the right to advise investors where to put their money. And reports have it that those who bought into the bonds and derivatives these banks peddled are planning to move court accusing these Wall Street firms of failures of due diligence.

Finally, the regulators and Congress are sitting up, as they did after the crash of the late 1990s which led to the passing of the Sarbanes-Oxley Act. US Congressmen are threatening to frame a law that restricts the freedoms investment banks and other financial entities have when creating bonds and derivatives by repackaging mortgages to sell them to investors around the world.

But all this is to wake up after the event has transpired. The "efficient" American financial system is clearly not geared to preventing a crisis, even if it proves capable of finding a solution. A solution that prevents the sub-prime crisis from overwhelming the mortgage business as a whole, by triggering a collapse in house prices, is imperative given the importance of the housing boom in keeping the American economy going. A slowdown in growth may be manageable. But a recession can send ripples across the globe.

All this has lessons for countries like India. First, they should be cautious about resorting to financial liberalisation that is reshaping their domestic financial structures in the image of that in the US. That structure is prone to crisis, as the dotcom bust and the current crisis illustrates. Second, they should refrain from over-investing in the doubtful securities that proliferate in the US. Third, they should opt out of high growth trajectories driven by debt-financed consumption and housing spending, since these inevitably involve bringing risky borrowers into the lending and splurging net. Finally, they should beware of international financial institutions and their domestic imitators, who are importing unsavoury financial practices into the domestic financial sector. The problem, however, is that they may have already gone too far with processes of financial restructuring that have increased fragility on all these counts.