Subprime fiasco and deregulation

December 08, 2008

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SUB-PRIME borrowers are defined as borrowers with a “bad credit history”. These borrowers have lesser credibility as compared to the normal conventional “prime borrowers”. Sub-prime borrowers also face high default risk, since some/most of them have faced bankruptcy in the past or have not been able to meet their debt obligations.

The broad category of these borrowers also incorporates the ones who have had lesser experience with debt and have a credit score (FICO score) below 620 (the score ranges from 300 to 850).

It is due to this high default risk on part of the borrowers that lenders demand greater compensation in form of higher interest rates. Sub- prime loans come in a variety of forms including sub-prime mortgages, car loans and credit cards. The most popular from among these aforementioned credit lines have indeed been sub prime mortgages. These mortgages are based on adjustable rate mortgages (arms) and are denoted by symbols such as 3/27.

The sum of the two numbers quotes the tenure or the time period of the mortgage (which in this case is 30 years), with the first number representing the number of years for which the interest rate on the mortgage remains fixed, regardless of market rates, while the subsequent number denotes the number of years for which the interest or the sub prime rate is adjusted according to a benchmark index.

According to the Wall Street Journal published in 2006, 61 per cent of the borrowers receiving the sub prime mortgages had FICO/ credit scores high enough to qualify as normal “prime borrowers”. But given the low interest rates for the first couple of years and an initial down payment lesser than $10,000, the “prime borrowers” were lured into taking on these risky sub-prime mortgages.

After the catastrophic events occurring on 9/11, the Federal Reserve (the American central bank), in an attempt to revive the collapsing American economy, started slashing the Fed Funds rate (inter bank lending rates), so as to increase consumption and spending by increasing money demand. Things were however running smoothly and the low interest rates were reaping the desired benefits for the American economy till the fear of inflation, or a persistent increase in the general price level, crept in.

In order to curb inflation, the Federal Reserve started increasing interest rates. This led to a proportional increase in the floating/adjustable part of the sub prime rates, which are linked to the benchmark interest rates and adjusted accordingly. This sudden and unexpected hike in the interest rate triggered massive foreclosures (seizure of property held as collateral by the lending bank) in the American mortgage industry.

The highly inflated so-called “real estate bubble”, which is very similar to the one currently being created in Dubai, finally exploded as the number of foreclosures in the American mortgage sector started picking pace. It was only a matter of time before the large investments made by mortgage firms and investment banks started going down the drain. To make matters even worse, a large portion of these “sour” mortgages were cut off into tranches, and sold off to investment banks, commercial banks and even the general public in the form of mortgage backed securities, after getting approval from different credit rating agencies, with the whole process being known as “securitisation”.

The originators(lenders) of these bad mortgages eventually thought that a bunch of hot shot investment bankers from Wall Street, by unleashing their creative skills, would come up with something innovative, that would help mitigate the risk of holding these “sour” mortgages by transferring the risk from their balance sheet on to a third party. This is a glimpse of how the process of securitization originated.

Some investment banks even went on as far as transferring their portfolios of “bad” mortgages to their fake off shore counterparts. One might wonder as to how these investment bankers were able to get good or at least decent ratings from credit rating agencies for the mortgage backed securities. Putting it in simple words, these highly qualified bankers were actually out “shopping” for credit ratings.

The rating agencies, after being intimidated by these investment giants, were forced to assign good ratings to their mortgage backed securities. After the formal window dressing process, these junk securities were sold off to investors, who unfortunately, were under the wrong impression of having sensibly invested their savings in lucrative ventures. Little did they realise that they would soon be weeping for having made the wrong investment decisions. It is also worth mentioning that some of these “dishonest” credit rating agencies are the same ones that have been very particular in downgrading our country’s credit ratings and making claims that we are on the verge of bankruptcy.

High rates of default by the sub prime borrowers led to the banks facing a liquidity crunch(severe shortage of cash), due to which they were unable to pay returns/interest to the holders of mortgage backed securities. Soon, the liabilities of many of these banks exceeded their assets, and once declared insolvent, many of these banks filed for bankruptcy.

The Federal Reserve played a key role in bailing out these distressed investment giants by acting as the lender of the last resort. But was it a wise decision to use hard earned tax payers money in providing temporary relief to those greedy banks that took on such risky investments? The $700 billion bail out plan by the Federal Reserve and the presence of the Federal Deposit Insurance Corporation (FDIC), seem to promote a phenomenon known as “moral hazard”.

Lets say hypothetically that a person gets a health insurance as well as a car insurance. Now this person is highly likely to drive recklessly and risk his life, given the fact that he knows that he is insured and will be compensated in the event of a loss or an injury. This explains the presence of moral hazard. Similarly, if the regulators keep on coming to the rescue of these banks who made certain reckless investment decisions by putting their shareholder’s and depositor’s money at stake, the banks are bound to behave in this fashion.

These private sector banks are the ones who have been favouring more of deregulation and comparing regulation with strangulation. But once in distress, they are the first ones to approach the government and the regulators for their assistance. A valuable lesson to be learned from the crisis is that a high level of deregulation can lead to a misery. In reality, there is no perfect example of a free market, or a market where there is no government intervention.

Certain checks and balances are necessary at the micro level in every sector of the economy to ensure it’s smooth functioning. The absence of a state can lead to anarchy and total chaos, which is exactly what we have observed in the sub prime debacle.