On subprime loans and securitization

This post follows the request from two of our readers in the shout-box on Indian Current Affairs.

Though we have covered it quite a few times in our blogs, I take this opportunity again for the benefit of newcomers to our blogs.

The term 'subprime loan' refers to loans advanced to subprime borrowers.  Subprime refers to the borrower's classification.  A borrower is classified as subprime when her creditworthiness is less than perfect.  That is her ability to repay the loans given her is fraught with high risk.  Therefore, the rate of interest on loans given to her attract higher rates and usually prepayment penalties.

Securitization of these subprime loans means pooling and repackaging these loans into securities that are sold to investors who are willing to buy them.  Because the lender has already invested his money in giving loans to subprime borrowers, by securitizing them, what he does is raise more money on the strength of the asset (subprime loans given by him) from willing investors.

Why would investors be interested in purchasing these securities which represent subprime loans?  Because they have the risk appetite.  They think that they will earn more return for their investment.  They think that the bank which has securitized the assets is so reputable that it will never palm off a bad security to them for investment etc.

Securitization has reportedly allowed banks and the original investors to raise about $10.50 trillion in the US alone.  In Europe it has reportedly enabled raising of $2.25 trillion in finance.  These figures pertain to the period up to second quarter of 2008.

Has it become a bad word now?  How did it lead to the present liquidity crisis?
Securitization per se is not bad.  What has made things worse for the globe is the fact that the banks which sold these asset backed securities (subprime loan backed securities) have indulged in all possible dirty tricks while packaging these securities.  They have mixed these poor quality assets with good quality assets (i.e., loans to prime borrowers) and have inflated the possible returns to investors and backed their claims with excellent ratings (AAA ratings and the like) from credit rating agencies.  A AAA rating from a reputable credit rating agency means that the asset is very good and the payment default -- of either the interest or the principal -- is NIL.  Such ratings have lulled the investors into making huge investments into these worthless securities. 

Okay.  So where was the problem? 
The problem arose when the subprime borrowers were not able to pay their loan instalments properly and well in time.  Because it is only then that the lenders will be able to make money.  Because the lender, in the meantime had securitized these loans, it is the ultimate purchaser or investor in these securities that suffered, the credit ratings notwithstanding.  So, the investors started demanding their money back by surrendering these securities to the banks.  That is how the banks ended up receiving a double whammy.  There was tremendous pressure for money.  Their securities investors started demanding money and the borrowers are failing to pay their loan instalments.  The bank was not able to raise more money because the other banks sensed that it is in trouble and refused to lend it money.  This resulted in the liquidity crisis -- i.e., banks refused to lend to each other because they are afraid that they will not be repaid their monies.

Hope this answers the questions posed in the shout-box.

What is Market Stabilization Scheme?

To understand this we need to take a look at the year 2004 when FIIs (Foreign Institutional Investors) started bringing in dollars to buy Indian stocks. This has resulted in an oversupply of US dollars in the Indian market. RBI bought dollars, thus creating an equivalent amount of rupees. This dollar buying raised forex reserves from $100 bn in January 2004 to about $300 bn by 2007-08. Thus there was a liquidity overhang that was caused by the inflow of dollars. This has forced the government to mop up the rupees by creating the MSS bonds.

MSS was introduced by way of an agreement between the government and the Reserve Bank of
India (RBI) in early 2004. Under the scheme, RBI issues bonds on behalf of the government and the money raised under bonds is impounded in a separate account with RBI. The money does not go into the government account. As on October 22, 2008 the balance under MSS stood at Rs 1,71,317 crore.

Global financial crisis. Why did it hit India? What should it do?

Why did the current global financial crisis affect India? What could India do?

India did not lend in a great way to subprime borrowers within its borders. Nor did its banks and financial institutions invest in the subprime related assets (barring the ICICI Bank to a small extant; but which by no means can really pull it down) in the US. In spite of this, how come we are witnessing a downturn in our financial fortunes? Why are our markets collapsing? What could be the possible reasons? How can this be explained?

In a very well written article Arthur Okun, Professor of Yale University reels out the reasons and the possible course of action that India should take. Worth a read. Do so here. Some excerpts which I found are worth our filing in our library:

Actually, the similarity of market behaviour across countries is evidence that something else, deeper than the causes that are usually given for the subprime crisis in the US, is at work.

The most fundamental problem is found in the swings of overconfidence that was seen in many countries since the 1990s, overconfidence shared by millions, billions, of people. And this confidence has been very strong until recently.

In the US, consumer confidence rose to near-record levels at the time of the peak in the stock market around 2000. This high level of confidence, shared in many other countries as well, was related to the booming markets and booming economy of that time. The booming markets and economy were in turn substantially buoyed by the high confidence, in a feedback loop.

Recently, confidence has been fading. In the US, confidence has fallen sharply since 2006, now below the lowest levels reached in the 2001 recession. This decline in confidence is seen in other countries as well.

But economic confidence, the true state of mind that affects asset markets and the economy, is difficult to measure by any survey. The seizing up of credit markets, amidst the reports of a financial spectacle that is going on in the US that is reminiscent of the Great Depression, certainly changes people’s thinking all over the world.

When people expect good performance from their investment assets, they tend to bid up their prices. That is what was happening in many places around the world in the years leading up to the current crisis, until markets collapsed.

The subprime crisis in the US is only a symptom of this fundamental problem. The deterioration in mortgage lending standards in the US since the 1990s is not an exogenous cause of the crisis. It is, in substantial measure, a consequence of the overconfidence that is the real cause. Mortgage lending standards deteriorated because people thought that home prices can only go up, and so they thought there is little risk in writing mortgages with few protections.

Even the loose Fed monetary policy in the US is, in a way, derived from the overconfidence. The Fed was willing to have such loose monetary policy because, under Alan Greenspan, it was so unaware of the bubble in home prices, thought it was just another sign of spectacular economic growth, and so felt no concern about it.

India is part of world culture and is not invulnerable to changing patterns of thinking about investment. Much of what happens in speculative markets in India is just the same as in other countries. But India must rank as among the most vulnerable in the world to speculative turbulence, since she appears to be undergoing such a dramatic economic revolution, a revolution that, along with China’s, is the talk of the world, and that allows imaginations to run wild and confuses traditional and sober thinking.

So, India appears not at all invulnerable to the current crisis. She urgently needs to take many of the same actions that are called for in other countries. Some serious work needs to be done to improve the quality of the financial markets, both expanding regulation and consumer protection, but also expanding the scope integrity of the markets and their retail products. Work needs to be done now to democratise finance, to make enlightened risk management available to everyone, by subsidising financial advice and education.

PS: While discussing about the current financial crisis and its impact on India, it is very important that we keep ourselves abreast of the reflections of some great minds like KV Kamath and Vinod Dham. Kamath feels that we are affected by sentiments rather than fundamentals and that the current crisis will test the economy’s resilience and provide it with insights to build an even more robust framework for reforms. Vinod Dham feels that the current crisis offers a boon for the country.