By Yousuf Nazar
 

The bankers define it as sub-prime lending while their detractors call it predatory lending. Simply put, sub-prime are more expensive (high interest rate) loans intended for people with impaired or limited credit histories, typically belonging to low income groups.
Defaults in over $1.3 trillion US sub-prime mortgages’ market have developed into the biggest global financial crisis in almost a decade. Defaults have not been limited to this loan market segment. The $1 trillion Alt-A (or loans to a slightly better quality of borrowers than sub-prime) mortgage market is also facing defaults. Hedge funds and banks have been exposed to this market through investments in mortgage-backed securities and other derivatives.

Mortgage-backed securities are those instruments through which the lenders sell the loans to the investors who then assume the risk of default by the borrowers. Hence, the defaults have led to investor losses, a global credit squeeze, tight liquidity conditions, growing risk aversion, and a widening of credit spreads. These mortgages (sub-prime and Alt-A) represent about 11 per cent of the US private debt securities’ market which is as big as the US stock market. A recent IMF report indicates that the losses from the US mortgages sector could reach $200 billion. Could it get worse? Would it lead to a recession in the US? What are the implications for the emerging markets?

What was once a problem confined mostly to the low-income borrowers and poor communities is quickly becoming a national phenomenon in the US. Last year, there were 1.2 million foreclosure filings in the United States, up 42 per cent from 2005. At current rates so far this year, some estimates put foreclosure filings to hit two to two and half million in 2007, or roughly one per 62 American households — a rate approaching heights not seen since the Great Depression in the 1930s.
It all originated with a global imbalance between the savings glut and the shrinking demand for credit. Central bankers, led by Alan Greenspan, let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system since 2001. Interest rates hit historic lows as the Fed funds rate was cut to one per cent. At the same time, corporates, the traditional mainstays in terms of borrowing funds to invest, moved to a defensive stance, having grown much more conservative in the wake of the Enron and WorldCom fiascos. Finally, the major developed countries began to gain a measure of fiscal discipline, with budget deficits shrinking, which further reduced the demand for credit on a global basis.
Emerging markets reduced their borrowing as their deficits turned into record surpluses. That imbalance between investors flush with cash and the traditional borrowers not really needing or wanting that cash meant that investors had to look for new markets to invest in. As the asset-backed securities, (ABS) market had been taking off and coming into the mainstream, a natural target was the sub-prime borrower - borrowers who in the past had wanted to borrow but who had been locked out of credit markets. Eager lenders met eager borrowers, with the mortgage originators, ABS underwriters, and credit ratings agencies playing the role of matchmaker, and the sub-prime boom was born.

Over the past nine years, the sub-prime market in the US produced more than $2 trillion in home loans and its share of total mortgages market went from around five per cent in 1999 to over 20 per cent in 2006. Some analysts maintain that lax underwriting practices, dangerous loan products, and a disregard for affordability set up vulnerable homeowners to fail. According to a US research institute, the Centre for Responsible Lending, over 60 per cent of sub-prime loans were not used for buying homes, but for refinancing existing mortgages. Even in 2006, sub-prime refinance loans accounted for a majority (56 per cent) of all sub-prime loans originated. The borrowers took advantage of low interest rates and rising home prices to take equity out of their homes. This phenomenon also supported consumer spending which accounts for over 60 per cent of US GDP.

The sub-prime boom led to a phenomenal growth in ABS and credit derivatives markets. Only about one in five mortgages is retained by the original lender. The rest — four out of five, roughly — are sold off. About one in four mortgages sold to investors is a sub-prime loan. This is crucial to understanding why sub-prime lending has rocked the financial markets. Financial intermediaries active in the mortgage market have complex webs of exposure.

Although the largest such institutions—the core commercial and investment banking group are believed to be sufficiently capitalised, diversified, and profitable to absorb direct losses, many hedge funds and smaller banks have proved to be more vulnerable. They also tend to have high leverage, that is, they use short-term funding to invest and can be forced to sell securities in adverse market conditions. Hedge funds are believed to account for around 48 per cent of the ABS and derivatives’ market and the banks nearly 25 per cent. About 80 per cent of the total is estimated to be held by the US institutions and the remaining mostly by Europeans.

A major reason for growing defaults appears to be the bad quality of the lending itself. This is borne out by the fact that one in every eight sub-prime home loans (12.9 per cent) originated in 2000 was foreclosed by May 2005. As the growth in the US economy accelerated during 2002-2005 after only a 0.8 per cent GDP growth in 2001 and inflation fears resurfaced, the Fed started raising interest rates. In series of interest rate hikes beginning in the later half of 2004, the Fed funds rate was raised from one per cent to 5.25 per cent. As most of the sub-prime lending was at adjustable (or variable) rates, the borrowers had to repay more in loan instalments as the interest rates rose. This compounded the miseries of sub-prime borrowers and contributed to rising delinquencies.

In June this year, two high profile hedge funds managed by a leading investment bank, Bear Stearns, who had invested in sub-prime mortgage securities, reported huge losses leading to withdrawals by investors and bankruptcies. The money and credit markets started showing signs of stress in June but the stock markets continued to move ahead. On July 26, Countrywide Financial, the largest US home mortgage lender announced losses of $1 billion on mortgage loans and sparked fears the sub-prime crisis would spread. The panic gripped the markets as sub-prime crisis turned into a liquidity crisis threatening to hurt corporations and other market participants.

The correction in the prices of mortgage-backed securities turned ugly and spilled over to the stock market. The Dow Jones lost over 500 points (or 3.8 per cent) over the next two days but the worst hit was the money market. The commercial paper (short-term borrowing instrument) market collapsed as more hedge funds and financial institutions reported losses in the following weeks. Since July 25, the US commercial paper market as represented by total outstanding amount has fallen by $369 billion or about 16.6 per cent.

As the crisis deepened and short-term funding sources dried up, the central banks in the US and Europe responded by massive injections of liquidity in the system. On August 12, the Federal Reserve (Fed) made a surprise cut in the discount rate (at which Fed loans to banks) of a half percentage-point, to 5.75 per cent. In a rare statement between scheduled meetings, the US central bank’s policy-setting committee said risks to economic growth “have increased appreciably” due to global credit crisis and financial market turmoil.

The measure was intended to calm the markets and the markets responded positively. On September 18, the Fed, in an aggressive attempt to keep turmoil in financial markets from damaging the overall US economy, cut the federal funds rate, which determines what banks pay to borrow money from each other overnight, by half a percentage point, to 4.75 per cent. The rate cut, the first in four years, will eventually lead to lower borrowing costs for consumers and businesses.
The Fed may have averted a crisis, but the risk of recession in the US seems to be increasing if the house prices continue to decline. In August, the sales of new homes in the US dropped more than forecast and home prices plunged by most since 1970. Nevertheless, US economy is quite resilient and grew at an rate of 3.8 per cent in the second quarter of 2007 and may not experience a recession after all.

However, investors can expect subdued economic growth, weaker US dollar, firm oil prices, and another interest rate cut in 2007-2008. Emerging market equities have proved to be remarkably resilient as their economies continue to grow and attract capital flows. However, they will not be immune to a fall out from a recession in the US. In the meantime, they should learn from the lending excesses that led to the crisis and have hurt the US economy.

yousufnazar@yahoo.com