Introduction
Subprime lending can be simply described as lending at a higher rate of interest than normal rate of interest, on loans to people with poor credit history or paying capacity. Basically it’s lending money at a higher rate of interest to a person who might not have the capacity to pay back. A subprime loan is offered at a rate higher than A-paper (best rated product) loans due to the increased risk. Subprime lending includes subprime mortgages, subprime car loans, and subprime credit cards, among others. A point to note here is that the term “subprime” refers to the credit status of the borrower (being less than ideal) and not the interest rate on the loan itself.
The Crisis Build Up in US
The housing bubble in the U.S. was fuelled by the fall in interest rates after the IT dotcom bubble burst in 2000. The prime rate fell from a high of 9% in 2000 to around 4% in 2002. This resulted in low rates for mortgage encouraging home ownership. This was further given a boost by demand boosting policies of the Bush administration after the 2001 attacks on New York and Washington. The drop in interest rate led to record demand for homes with ownership of homes rising from 64% in 1994 to 69.4% in 2004. This increased valuation of homes triggered refinancing of mortgages with low interest loans. Also, the added value was used to take out second mortgages for consumer spending.
The increase in home prices on the backdrop of low interest rates continued till 2004 when the residence prices touched the record highs. However with a construction boom the inventory of unsold houses began to grow and a demand supply mismatch got created due to rising interest rates. However under these circumstances home owners refused to lower prices from the peaks this further fuelled the growth in inventory. The aggressive lending policies of the lender were a major trigger for the crisis. Securitization of the debt added another lever to this crisis.
Impact
The sub-prime crisis brought the stock market party to an abrupt halt leading to a crash world wide as the unfolding of the crisis put a halt on the excess liquidity prevailing in the market. The hedge fund industry as a whole generated its worst performance since 2000, with the average fund declining more than 3%. The impact is so large that losses from securities linked to subprime mortgages may exceed $265 billion as regional U.S. banks, credit unions and overseas financial institutions write down the value of their holdings. Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds. These have fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most asset classes, even those considered safe by the ratings agencies. The subprime crisis has given a major setback to the growth in the financial services sector with record layoffs happening. The major companies hit are Citigroup, UBS, Merrill Lynch and the ailed Bear Stearns. Citigroup is likely to cut between 17,000 and 24,000 positions over the course of the year through a combination of layoffs, attrition and selling off businesses.
Lessons for India
Although the economic factors like plummeting interest rates, lack of government oversight and a very lender friendly investor market for credit risk transfer are the major factors that led to the subprime crisis, there are many other factors that can be listed below:
Accounting Issues
Two of the biggest exposures to the subprime market are by Fannie Mae and Freddie Mac – the US government agencies taking care of the mortgage related issues. Recently, feeling the heat of the subprime crisis, Fannie Mae announced that it will sell an aggregate of $5 billion in two placements of preferred stock to qualified institutions buyers. This is in fact the largest capital placement ever undertaken by the mortgage-financing giant. A lawsuit was filed against the top executives of the company accusing them of purposely inflating the price of its publicly traded common stocks to deceive investors about the financial state of the company. The enquiry by the SEC (Securities and Exchange Commission) brought into light many accounting issues the primary being the capital adequacy of the financiers. The issue was that Fannie Mae accounted for some securities as “available for sale” on which there were $ 32.4 billion of losses. Fannie Mae basically did not account for the losses on the cash flow hedges whose effectiveness was spread over a period of 26 years.
The impact on the Indian markets was felt when ICAI asked the companies to mark-to-market derivate transactions and recognize losses or adopt their accounting standard on the subject well before it became mandatory. The root cause was the complex hedges, derivatives and other instruments leading to more accounting irregularities. India as of now does not have any such complex derivatives and taking steps right now will ensure that these irregularities are not repeated in India.
Complex Model Failure – FICO
FICO score provides a cut-off score to help the lender distinguish the “good customers” from the “bad customers”. But this measure is not 100% accurate. This scoring pattern was very good when it came to scoring prime borrowers and showed good results, but the lenders when overboard when they relied on this system for subprime borrowers too. This resulted in an increase in the number of bad loans that were granted. So ideally, instead of focusing on just one parameter, the idea should always be to consider more parameters to arrive at a better lending decision. This means that excessive reliance on complex mathematical models does not ensure that the decisions are foolproof; it only shows that models are only as good as the results. So models should only be used for supplementing the credit decision that should be based on other parameters evaluated.
Moral Hazard
The basic tenet of the subprime lending is to reduce exposure to any single client by “passing the parcel” — because a predominant portion of debt is structured in form of tradable debt securities. This is good for a bank, but not good for the economy. The bank that floats an issue has no incentive to see that the borrower honours obligations till maturity, because very shortly, its exposure to that client gets reduced to near-zero. This creates a moral hazard — “sub-prime” borrowers find it easy to raise money because of banks’ appetite for debt securities. This is why no bank now believes that an AAA+ rated debt is really a safe bet.
Risk Spreading
Another striking point that came up with this crisis and a follow up of the previous point is that – risk spreading is not the same as risk elimination. In fact as the risk is spread globally it becomes all the more difficult to assess the impact of the loss and its ripple effects show up in the most unthought-of places. So the popular perception prevalent that once the risk is spread, by bundling it with the other assets, it leads to risk reduction is extremely wrong.
Asymmetric Information
Since the investment firms were unaware of the borrower quality and the expected default rate, they bought these securities at a high value as compared to the fair price. This resulted in inflated balance sheets which had to be written down on a marked to market basis putting the capital adequacy of these banks under threat.
Credit Analysis of Borrower
One of the important lessons for India to learn is that no matter what measure you take, the most important step in the lending process – analyzing the credit history of the borrower should be done with utmost due diligence. With the ongoing credit squeeze, stricter lending practices should be followed and there should be a greater background check on the borrower to curtail the foreclosures.
Rating Agencies
Credit rating of the instruments that are created out of this industry should be constantly reviewed by the rating agencies. The rating of the securities should never be a onetime event but should be an ongoing process. An automated and objective mechanism should be put in place. The analysts at the various rating agencies should be made to attend training to bring more standardization within the rating agencies – the methods should be objective, transparent and replicable. Also in the wake of BASEL II implementation, greater regulatory checks should be performed by the rating agencies.
Central bank & NHB
Central bank and NHB – National Housing Bank – that takes care of all the Housing Finance companies should be proactive in formulating stricter guidelines. As such there is not much of a subprime market in India, but measure need to be taken right now to curb any issue that might arise. Also the system of securitization is not that prevalent in India and so as of now it is easy to trace the instruments, in US this was one of the major issues as the chain of instruments was so large that nobody could decipher their reach.
Conclusions
Considering both the pros and the cons – the potential gains from the subprime lending are huge. It is one of the important sources of financing for home ownership, leads to greater integration of the capital and the financial markets and also leads to an increased source of funds for the banks and other financial institutions.
To sum up all – “Complex mathematical models can supplement other tools when it comes to assessing credit risk, but cannot replace them. There is no substitute for the old-fashioned technique of doing a proper due diligence of the ultimate borrower.”
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