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In a nutshell, a sub-prime loan is a loan advanced to a person or household that cannot afford to repay it. The lenders targeted weak sections of society, who welcomed the opportunity of having money and agreed to initial low payments that then rose to the regular market rate – known as adjustable-rate mortgages. The borrowers could not afford the higher rate, hence began to default. Thus began the crisis as we see it today.
This can also be called “predatory lending,” in which the loan salesman persuaded people to sign on the dotted line with inducements like no documents or proof of income. There are laws against predatory lending, but mortgage-based lending is not included. Hence the salesman with impunity could walk from house to house and lend money. This activity reached a crescendo from 2003 to 2006. Most of the loans were advanced to minorities with little or no credit history.
The genesis of the game lay with the Federal Reserve, which in 2001-2002 lowered interest rates to 1 percent to get through a mini-recession. The economy recovered and bounced back with laurels. Then in July, 2004, the Fed began a cycle of interest-rate hikes. The rate reached 5.25 percent in June of 2006.
That was just about the time the early adjustable-rate mortgage holders were coming into the new higher payment schedule. These mortgage holders could not afford higher payments, hence began to abandon their houses. Mortgage companies promptly took over the houses. Too many houses in the market lowered property prices. Homeowners were shocked at their reduced personal asset base. This was one part of the crisis.
The second part of the crisis involved banks and money managers. Since U.S. banks do not offer sub-prime mortgages, one may think they should not be affected. On the contrary, they have been the worst affected. Sub-prime lender institutions and trading houses packaged sub-prime debts into attractive investment vehicles. Banks, traders, and hedge funds on all the continents of the world snapped up these investment instruments.
When the sub-prime crisis began to unfold in July, 2007, the banks found themselves saddled with worthless investments. Major banks that had bought into these instruments began to declare them dead investments. Their stock prices dropped. Their liquidity was affected. They began restricting lending. Common borrowers, including businesses, suffered.
The entire banking sector all over the world unwittingly became the victim of a crisis to which they were not a party. Their only connection to it was that they had bought these attractive investments.
Initially, the European Central Bank sprang into action to prevent a liquidity crunch, throwing in new lifelines. The United States began active action when the Bear and Sterns crisis in March this year reached the endpoint and it had to be sold at a cut rate, in a hurry. In July IndyMac, a California mortgage bank, went into a tailspin and is now operating under federal protection. It is just a matter of time till other larger mortgage companies like Fannie Mae and Freddie Mac do the same.
There are four major players in this crisis. First, the sales force that sold mortgages door to door, sweetening deals with incentives. Second, the brokers who knew the salesmen’s tricks but were lured by greed into turning a blind eye; they handled about 70 percent of all sub-prime mortgages. Brokers are protected by legal leniency. Under U.S. law, investors who buy securities backed by mortgages or even the actual mortgages will not be exposed to lawsuits for fraud. Third, the mortgage banks, which repackaged and restructured these loans into mortgage-backed bonds and collateralized the debt obligations. Today, they have major exposure. Some are finding it hard to operate with no cash at hand. Fourth, the regular banks all over the world, including hedge funds, that snapped up this debt initially. They are the worst affected.
Now, if one link in the above chain is broken, the whole house of cards will collapse. In the sub-prime mortgages the weakest link is the borrower. They have defaulted in large numbers starting in the beginning of 2007. This was the beginning of the current crisis.
Canadian banks, whose exposure began to be known in September 2007, initially declared few losses. In fact they were putting on a brave face. As more mortgage holders defaulted in the United States, their exposure increased. They began to admit big losses late in 2007. Since then their stocks have tumbled. An average 40 percent decline in stock value has taken place in all Canadian banks, which is not good news for the Canadian economy.
The Chinese do not do much banking with international banks on sub-prime and mortgage-related investments; hence they have not been directly affected. But they cannot remain oblivious to such a worldwide problem. Their exports may get hit and their banks’ stock value may tumble.
The Indian position is not much different from the Chinese. There is one curious area where the Indian economy will feel the impact – that is Indian software and business process outsourcing companies. They are the prime movers in the loan and mortgage processing area. A decline in this business is likely to hit a few BPO companies.
Most of the impact of the sub-prime crisis is in the United States, followed by Europe and then Japan. In the United States, the first failure of investment banks was Bear and Stearns in March. Then Merrill Lynch smartly sold US$800 million of bonds used as collateral to advance loans to Bear and Stearns hedge funds. This fund had been betting heavily on the sub-prime mortgage market. The same thing happened at Goldman Sacks, but it managed to overcome the problem.
To a great extent, the Federal Reserve in the last six months has focused on putting more liquidity into the market and underwriting loans for failed investment houses. This has saved the big bankers and the investment houses. In short, the Fed may be saving 70,000 or 100,000 high-income jobs. The Fed is not focused on the little guy who is facing a foreclosure or the construction industry, or suppliers or retailers who live on sales to new homebuyers. There may be millions of them facing hardship.
The U.S. Congress, in a rare bipartisan mood, has decided to help the beleaguered homeowners. Help may be given to the troubled adjustable mortgage homeowners. A US$300 billion foreclosure rescue, which the Congress is considering now, will help some. For1.5 million foreclosed mortgages of 2007 and 2.5 million pending foreclosure in 2008, this help is a bit too late, however.
In summary, the sub-prime problem is here to stay till 2009 or maybe 2010. The economic health of the banking sector and general wellbeing of the people who have lost their houses will not be restored for a longer time. The rest of the world should be a bit wiser and not get involved in smart-looking investment vehicles, which have the hallmark of a scam.
The United States will survive, however. It survived the savings and loan scandal of the 1980s and the junk bond scandal of the 1970s. It will survive this crisis too.
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(Hari Sud is a retired vice president of C-I-L Inc., a former investment strategies analyst and international relations manager. A graduate of Punjab University and the University of Missouri, he has lived in Canada for the past 34 years. ©Copyright Hari Sud.)
