Subprime Crisis: Impacts and Implications

Subprime Crisis: Impacts and Implications

Subprime mortgage loans are made to home loan borrowers who are having higher credit risks compared to prime mortgages because of irregular payment in the past, higher amount of debt compared to income level or any other such factors. Major causes of subprime crisis include the inability of homeowners to make their mortgage repayments, poor judgment by borrowers as well as lenders, excessive speculation in property price, high level of personal and corporate debt, and lack of proper regulation and innovation of structured financial products. The subprime crisis is likely to have long- lasting economic impact on the world market.

The term `subprime lending' refers to the practice of making loans available to borrowers who do not qualify for normal market interest rate loans due to various risk factors, such as income level, size of the down payment made, credit history, and employment status. Subprime mortgages are defined as housing loans that do not conform to the criteria of prime mortgages and also have a lower probability of full repayment of mortgages. Subprime mortgage loans are made to home loan borrowers who are having higher credit risks compared to prime mortgages because of irregular payment in the past, higher amount of debt compared to income level or any other such factors.

According to the federal banking and thrift regulatory agencies, subprime mortgages are those made to borrowers who display, among other characteristics, (i) a previous record of delinquency, foreclosure or bankruptcy, (ii) a low credit score, and/or (iii) a ratio of debt service to income of 50 % or greater (Office of the Comptroller of the Currency, et. al., 2007).

Subprime mortgages were mainly responsible for the increase in demand for housing and home ownership rates in the US. The overall US home ownership rate increased from 64% to 70% from 1994 to 2004. This surging demand helped fuel housing prices and consumer spending. Between 1997 and 2006, American home prices increased by 124%. Partly, it was due to the encouragement by the federal government for the consumption economy after the September 2001 disaster to boost domestic economy based on consumer spending.

During the period of the housing property bubble in the US, when property price was having continuous northward journey, many homeowners used the increased property value to refinance their houses with lower interest rates available in the market. Such second mortgages against increased value of home ownership were used for personal consumer spending. In 2007, the US household debt was 130% (as a percentage of income) which was considerably higher compared to 100% recorded in the last decade. The US subprime crisis began after the housing bubble burst, which ultimately resulted into high default rates on higher risk borrowers such as subprime and other Adjustable Rate Mortgages (ARM). Subprime borrowers were influenced by mortgage loan incentives and trend of rising home prices to assume large mortgage loans considering that they would be able to refinance existing mortgage loans with more favorable terms later. Once, the prices started to drop sharply, home loan refinancing became more and more difficult. Defaults and foreclosure activity increased steeply as ARM interest rates reset higher, making it more difficult for borrowers to pay.

Subprime Crisis: Causes

Many factors related to housing and credit markets that emerged gradually over a number of years were responsible for subprime crisis. Major causes of subprime crisis include the inability of homeowners to make their mortgage repayments, poor judgment by borrowers as well as lenders while dealing with property loans, excessive speculation in property price during the strong period of economy, high-level of personal and corporate debt, lack of proper government control and regulation, and innovation of structured financial products that concealed the risk of mortgage default for subprime clients. Subprime mortgages amounted to $35 bn (5% of total originations) in 1994 has increased phenomenally to $600 bn (20%) in 2006.

According to a research study conducted by the Federal Reserve of the US, between year 2001 and 2007, the average difference between subprime and prime mortgage interest rates decreased drastically from 280 basis points to 130 basis points. It means, the risk premium considered by lenders or loan issuers to offer subprime loan to clients declined. Most surprisingly, this has happened even though credit ratings of subprime borrowers declined during this time period. Mortgage underwriting practices such as automated loan approvals have also been responsible for subprime crisis as such approvals were not subjected to appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting.

Process of Securitization

Subprime mortgages are mainly securitized in the form of Mortgage-Backed Securities (MBS). In a traditional process of mortgage, bank originates a loan to the home loan borrowers while the credit default risk remains with the issuing bank. With the initiation of securitization, the traditional process has changed from originating to distributing process. Here, the credit default risk is shifted or distributed to investors through MBS and Collateralized Debt Obligation (CDO). Securitization is a type of structured finance and involves the pooling of financial assets, mainly for assets for which readymade secondary market does not exist.

Securitization turns mortgage loans into financial securities by taking existing loans or assets backed by their future cash flows. Securities are sold in the market after separating them into tranches. Main advantage of securitization is that, the lender or the originator of the loan gets a lump sum amount rather than the interest and principal payments over the loan's term and period. By this way, it provides lenders additional cushion and flexibility to re-lend the capital for the new projects. Hence, it provides the capital to investors at lowest cost, increases liquidity for lenders, and helps lenders and investors better manage their financial risk.

Securitization process provides secondary market for mortgage transactions, hence, issuers of mortgages were no longer compelled to hold them to maturity. Pooled assets created by securitization act as collateral for new financial assets issued by financial institutions or those owning such underlying assets. By this way, mortgages with a high risk of default could be derived effectively through MBS and CDOs by shifting inherent risk from the mortgage issuer to investors.

Bankruptcy of Lehman Brothers

One of the major causes of Lehman Brothers' (the fourth largest securities company in the US) default was its exposure to the subprime market. In recent years, many home mortgages issued in the US were made to subprime borrowers. Compared to prime borrowers, subprime borrowers are having lesser ability to repay the loan based on various criteria. During 2006-07, housing prices began to drop in the US causing mortgage delinquencies to soar with huge loss to financial firms as they held financial securities backed with subprime mortgages. This resulted into a large decline in the capital of many banks and government-backed enterprises of the US.

Lehman Brothers was a key player in the MBS market. A single MBS might consist of number of mortgage loans clustered together and enclosed into a set of mortgage securities which can be bought and sold in the secondary market for securities. Although, the subprime MBS market was having high proportion of inherent risk, it looked much more attractive since MBS market was growing at exponential rate with market size in trillions, having doubled between year 2001 and 2003. Many banks and financial institutes turned to such riskier investments as it promised greater rewards during the period of relatively slow economic growth. Massive size of MBS market also tempted many finance and securities firms in it. As residential property prices soared, homeowners and mortgage borrowers used their homes as collateral for increasing indebtedness and that enhanced debt also provided the starting point for a stock market bubble.

Lehman Brothers had huge exposure to property derivatives such as MBS and CDOs. These mortgage derivatives were attached to underlying assets such as value of homes and mortgages. With beginning of property price crash, the value of Lehman Brothers' investment started to decline sharply. Lehman Brothers also had a large chunk of leveraged assets and was exposed to significant portion of subprime MBS. It suffered severe credit crunch as it was exposed to huge amount of bad debt. Lehman Brothers collapsed because it failed to raise enough capital to secure their debts and filed under Chapter 11 of the United States Bankruptcy Code on September 15, 2008 causing panic in the global financial market.

Lehman Brothers' working model of securitization involved buying loans from other banks and then selling them off as MBS in the secondary market. In this process, banks would pay the monthly interest they earn out of that loan to Lehman Brothers. Finally, Lehman Brothers would pay to the investors who bought the MBS. Here, main risk is that if the loans are unpaid and defaulted then the bank is not obliged to pay Lehman Brothers even if Lehman Brothers is required to pay the customers who bought the MBS. Hence, when mortgage loan customers started defaulting on loan payment, banks stopped paying Lehman Brothers. All these reasons were the culprit for the downfall of Lehman Brothers. After bankruptcy liquidity crisis deepened further having an immediate impact on American International Group (AIG), the biggest US life insurer. To ease liquidity crisis, AIG received emergency loans from the US Federal Reserve on September 17, 2008 and was effectively bailed out and placed under government supervision.

Securitization Market: Indian Scenario

Securitization market in India is of recent origin but looks promising. Indian structured finance market registered a growth rate of 44% to Rs. 370 bn in year 2007 out of which, 65% of securitized assets originated from banks and the remaining 35% from non-banking financial companies. Table 1 shows the growth path of Indian securitization market.

Subprime Crisis and Credit Monitoring System

Subprime crisis is the most often heard word in financial circles worldwide in the recent past and has the lasting impact on the world's leading financial institutions, brokerage firms, investors as well as overall global economy. The innovative financial products such as mortgage derivatives that ultimately led to the subprime crisis were produced by global financial firms. The environment of irrational euphoria regarding property boom was responsible for subprime crisis which ultimately resulted in the financial and stock market meltdowns. The US markets witnessed prolonged period of low interest rates beginning from year 2001, which encouraged housing loan borrowing and escalated housing prices. As the loan issuers and mortgage lenders provided lenient and uncontrolled lending, coupled with innovative loan mortgage products, which provided more convenient repayment options at the start of the mortgage for attracting home loan customers, housing boom started assuming a bubble like proportion. These favorable home loan market situation encouraged borrowers to buy homes far more expensive than their financial situation that warranted or supported such hefty borrowing and subsequent mortgage installments.

The banks and major financial institutions refinanced these loans of home mortgages by repackaging them into different types of financial products and selling them to financial institutions and other investors in the secondary market for securitization. However, the situation changed noticeably after a series of interest rate hike by the US Federal Reserve. Such policy of US Central Bank led to increase in interest rates of floating housing loans and subsequently rising defaults by home loan borrowers. As a consequence of subprime crisis, many major banks and financial institutes reported subprime-related losses running into billions. Ripple effects of subprime crisis were felt not only in the US financial markets but across the global financial market. The deteriorating situation was further compounded by the failure of financial markets to recognize the fast changing mortgage scenario and suitably modify their lending and risk management practices. The credit and default risks inherent in new mortgage structures were not fully recognized. Hence such risks were not fully factored in the overall credit ratings of the repackaged financial offerings such as MBS.

Basically, there is a dominant need to streamline and strengthen the credit rating system for thorough assessment of the home loan borrower's creditworthiness. Any lapse at this stage is likely to cause series of unwarranted consequences in the future, no matter how vigorous the monitoring processes are. The central regulatory agencies will have to check that banks and financial institutions do not follow lenient, imprudent and predatory lending practices. It is imperative that, banks and financial institutions share the credit history of home loan borrowers to better assess their creditworthiness. One such step in this direction could be to encourage and support usage of the services of the Credit Information Bureau (CIB). For all banks and financial institutions, institutional membership as well as sharing of credit information with CIB should be made obligatory. This will help in sharing of all relevant information pertaining to individual borrowers among all the lending banks and financial institutions.

Major drawback in the credit rating mechanism has been that the credit rating processes largely rely on the past performance record. For MBS, such historical record has been very impressive. But such credit rating processes or models do not take into account newer or imminent macro risk. Even the risk arising from newer mortgage structures such as negative amortization mortgage or adjustable rate mortgage, which is more prone to loan repayment default is not considered.

Credit rating models used by the originators of mortgage loans and rating agencies must be able to comprehend potential risks in such financial innovations and safeguard so that such impending risks are adequately accounted in their rating processes so far as new risk is concerned. It must also ensure constant credit monitoring so that the fast changing environment of the global economy is reflected and accounted in the credit rating processes. Credit rating agencies should learn lessons from subprime related crisis to modify their rating methodologies and models to incorporate certain predictive elements and build greater rigor in their rating mechanism. Speedy actions by credit rating agencies in identifying toxic mortgage backed securities will help in boosting investor confidence in the efficiency and effectiveness of the entire credit rating system.

Implications of the Subprime crisis for India

The subprime mortgage crisis and its potential impact on US economic growth has raised concerns whether growth in India will be adversely affected. In current scenario of financial turbulence, accompanied by global credit crunch and major slowdown in US and European economy, it is very important to understand the overall impact of all these factors on India's growth prospects. Hence, it is necessary to put this whole crisis in the Indian perspective, analyze the chain of cascading events responsible for this turmoil, and frame action plan to avoid or reduce the possibility of such occurrences in the future.

There are two main channels viz., financial and delivery or trade channels through which a global credit crunch and a recession in the US and Europe can affect India. In financial channel, a decline in capital inflows from abroad and lower access of Indian corporate to credit in international markets will affect India. In delivery or trade channel, a slowdown in exports of goods and services from India to the US and European countries might impact India. Impact through delivery or trade channel appears to be small as Indian exports are well diversified; however, the financial channel impacts are likely to be more significant through a cutback in capital inflows. The expected impact of a global credit crunch and slowdown in the US and European economy on India through these channels is likely to be negative for a near future. Nevertheless, the subprime-related events which have unfolded in the recent months in the US and Europe offer valuable learning for an emerging country like India. For India, following key factors can help insulate it from the direct impact of subprime-related global crisis.

Sound Banking Practices

The root cause of the subprime mortgage crisis is the unsound credit practices that emerged in the US market. Besides relying on credit ratings, banks and financial institutions will also have to play a key role in avoiding any credit shocks by carrying out proper due diligence of underlying securities and home loan borrowers. They need to strengthen their risk management framework in view of increasing complexities in financial products, services, and customer requirements.

The Reserve Bank of India (RBI) is taking series of proactive measures to avoid or curb a subprime-like crisis in India. It has asked banks and financial lenders to set up credit counseling centers across the geographic locations that will alarm borrowers if they are raising mortgage and personal loans beyond their means. This is necessary when borrowers are bombarded with numerous credit cards and personal loans offers. The main reason for subprime crisis in the US was disbursement of mortgage loans to those people who cannot afford mortgage repayment. It is envisaged that such major financial crisis could have been controlled if loan borrowers were more aware of their total liabilities. According to the RBI directive, such credit counseling centers should provide free advice and should not indulge in selling the financial products while providing investment advice. The RBI has asked banks to set up credit counseling centers either individually or collectively.

Controlled Derivatives Market

Derivatives for mortgage products are innovative financial securities, which can spread the default risk attached to housing mortgage loans. However, imprudent application of such derivatives products can lead to excessive leverage as it happened in subprime crisis of US. Any failure in derivatives transactions leads to such a chain of events that it will be nearly impossible to quantify the risk of exposure to bad mortgage loans. The RBI and the Government of India should prohibit excessive use of such derivatives products.

Limited Investment by Indian Companies Abroad

Although the Indian capital and financial markets are experiencing the domino effect of global financial meltdown, the Indian banking system have remained fairly detached from any direct or immediate impact of the US subprime crisis. This is due to limited exposure or non-exposure of the Indian banks to subprime loans in the US. Yet, there was a major impact of subprime crisis on the Indian equity markets as many Foreign Institutional Investors (FIIs) sold off their securities and investments into Indian firms to partially balance their huge subprime mortgage losses in foreign market. The FIIs have and, as of date, are continuing to withdraw from the equity markets of emerging countries such as India to cope up with subprime related losses in the US market. In the period of global financial crisis for long-term growth and sustainability, well-planned strategy for investment in foreign market is required.

Excessive investment in the overseas derivatives market by banks and financial institutions is required to be regulated. As a spillover effect of subprime crisis, BNP Paribas of France and Macquarie Bank of Australia have been severely affected because of their exposure to such overseas investments in derivative products. The exposure of Indian banks to the subprime crisis of US is very limited. However, exposure of ICICI Bank to overseas derivative market, although minimal, has greatly impacted its enterprise value. ICICI Bank has faced a net loss of Rs. 375 cr in the current banking crisis.

As the subprime crisis intensified globally, counterparty risk aversion has become rigorous and has encouraged banks and financial institutions to carry significant amount of liquid assets as precautionary measures. This has resulted into banks restricting lending and exposures to corporate and increase in outflow of foreign fund from the capital market. These adverse global developments will drastically slow down capital inflows into India. For year 2008-09, it is estimated to be between $40 and $50 bn. The recent downfall in the Indian and global capital markets, also a reflection of increased global risk aversion and reduction in market liquidity will have a negative impact on global investment and consumption patterns.

Indian firms were active in the foreign debt markets for financing overseas expenditures denominated in foreign currency, and with mergers and acquisitions. However, given the situation of tight liquidity in the foreign debt market and loss of risk appetite on the part of foreign banks, it is becoming increasingly difficult for Indian corporate and banks to raise foreign loans. Pricing for foreign borrowing by even blue-chip Indian borrowers (e.g., Tata Motors, Reliance, etc.) has increased significantly since the beginning of January 2008.

Central banks across various countries including India made quick decision to cut interest rates along with declaration of economic stimulus packages by respective governments. All these collective steps were taken to control risks to broader economy created by subprime crisis and subsequent financial meltdown. It is envisaged that these measures will stimulate economic growth and rebuild confidence in financial and capital markets. Effects of subprime crisis and subsequent financial turmoil on global stock markets have been severe. Between January 1, 2008 and October 11, 2008, market capitalization of US stock market had suffered $8 tn in losses, as their value declined from $20 tn to $12 tn. Losses in other 9 countries have averaged about 40%.

The major turbulence in the global capital and financial markets and subsequent lower risk appetite of financial institutions and FIIs will impact India's ability to finance its capital intensive infrastructure projects. As credit growth has not responded positively to liquidity strengthening measures by central banks across the globe, it is envisaged that the supply of long-term fund for financing of infrastructure projects worldwide will remain restricted for the next 12 to 24 months. The need, therefore, for developing the local long-term debt market has assumed even higher urgency. Subprime-like crisis in India seems unlikely given the current state of regulatory affairs. Despite rapid credit growth in recent years, the home loan mortgage market in India is nowhere near the levels of developed countries, such as the US or the UK. Mortgage loans as a percentage of GDP in India are still at a small percentage as compared with the US and the UK. The approach of the Indian regulators for financial markets has been cautious, balanced and forward-looking. The RBI's policy of strict watch on market liquidity to ensure that the money supply (and hence inflation) is kept within manageable limits, is helping in avoiding any such full-blown financial crisis, like subprime crisis.

Conclusion

The aftershocks from subprime crisis have caused widespread panic in global financial and capital markets encouraging investors to abandon risky mortgage bonds and volatile equities. The subprime crisis is likely to have long-lasting economic impacts on the world market. Declining house prices in the US have reduced household wealth and the collateral for home mortgage loans, which is placing a downward pressure on consumption. The unemployment rate in the US rose to its highest level since September 1992, reaching 7.6% and non-farm payrolls fell by the largest amount in 34 years in December 2008. Immediate impact of subprime crisis on global banking industry involves fundamental changes in bank business models eliminating volume and income, the net effect being large percentage reduction in credit available. The subprime crisis has altered investor and lender risk preferences in a big way. Structured financial products are being avoided by investors and financial institutes as they prefer holding in favor of cash or cash equivalent securities.

-- Prof. Pankaj Madhani
Faculty Member,
IBS, Ahmedabad.
The author can be reached at
pmmadhani@yahoo.com