*Following artile published in Mumbai Mirror - Sep 20 2008, by Mr Ajit Ranade on American Sub Prime Crisis*
*House of (Credit) Cards * *As the mortgage market crumbles, many investment banks are folding up * It all began with sub-prime loans. These are loans given to people who wouldn't normally qualify to get a housing loan. In extreme cases these would be people with no income, no jobs and no assets, and hence called NINJA loans. Why would any bank be foolish enough to give such loans at all? The reason is a combination of reckless optimism, greed, competition and euphoria. A collective sense of optimism said that house prices can only go upward. So even if your NINJA borrower defaults, you can repossess his house, sell it for a profit (since house prices are continuously rising), and recover the loan. Greed ensured that since NINJA loans had a higher interest rate, the profits on these loans were also higher. Such loans were practically pushed onto unwary borrowers, often from poorer neighbourhoods, with teasers like no down payment, no principal repayment for first two years and a very low initial rate. The euphoria continued because indeed house prices kept rising higher and higher. That was mainly because the economy was flush with money, thanks to the liberal monetary policy followed since 2001. Indeed, it was quite common for people with existing housing loans to repay their loan with a new loan at ever lower rates, since banks were only too willing to refinance. This in turn was because banks knew that liquidity was a m p l e , t h a n k s to low interest r a t e s . The "inf l a t i o n " in housing prices and stock prices was welcomed by all — consumers, borrowers and banks. Around the middle of 2004, some of this inflation started creeping into actual inflation, i.e., of daily items like food, petrol, electricity and clothing. Hence, interest rates started rising. By the middle of 2006, interest rates had risen substantially, and the sub-prime borrowers had a rude awakening from their initial no down payment two-year honeymoon. Their monthly instalments rose so sharply, that many chose to walk away and default. Most houses (the collateral) had to be repossessed and sold. As this phenomenon caught on, housing prices collapsed. In the olden days, loans were given and recovered by banks over 15 to 30 years. In modern times, a bank gets "rid" of the loan as soon as it is made. The loan parcel is eagerly bought by investment banks who merely slice it into several pieces (securities) and sell it to thousands of investors. Very quickly the loan "risk" is widely dispersed among investors. So long as loans are healthy, and interest rates keep going down, the NAV of these little pieces (units) of the securitised loans keeps rising. This business was so lucrative that most investment banks in the US and around the world got into it. The total value (or aggregate NAV) of these mortgage backed securities (MBS) is in trillions of dollars. And then in the middle of 2007, the sub-prime bubble burst. This was oneseventh of the MBS market. But it had infected other parts of MBS. Greed was replaced by fear. Investors fearing NAV erosion, started encashing their securities. Security issuers (like investment banks) had to frantically come up with quick cash. Meanwhile inter-bank borrowing was becoming horribly expensive. Most emergency financiers flatly refused to help beleaguered i-banks. One such i-bank was Bear Stearn, which received emergency funds in exchange for being bought out completely. Another giant i-bank Merril Lynch also agreed to be bought out, almost as a preventive measure, before it got into dire straits. And then last week it was the turn of Lehman Brothers, another blue chip ibank. It had $600 billion in assets, and 25,000 employees. But persistent rumours about its mortgage exposure caused its shares to drop by 99 per cent from 65 dollars to a few cents. With no rescue in sight, it was forced to declare itself bankrupt and gain temporary relief from marauding creditors. All the king's men cannot put this Humpty Dumpty back up again. Interest rates started rising and by the middle of 2006, they had risen substantially, and the sub-prime borrowers had a rude awakening Ajit Ranade on the wheels that make Mumbai run — money and economy Cheers -- Anand Lakhmani Senior Manager - IT, Risk Management Dept, Bank of Baroda Corporate Center, Mumbai - 51 Ph : 98191 28191
