noticeable feature of growth dynamics in contemporary
times is that investment and consumption spending
by households has been an important stimulus to growth.
Such spending, in turn, has been stimulated by changes
in the financial sector that have increased the volume
of credit, eased interest rates and made credit available
to individuals and firms that would have earlier been
considered inadequately creditworthy.
The last of these is of relevance, because it draws
into the market for housing and non-essential consumption
a set of consumers, who would not be present in these
markets if their spending was determined by their
current income. A credit boom expands the market for
certain assets and commodities at a much faster rate
than is possible if demand growth were dependent purely
on either income growth or on changes in income distribution.
Needless to say, income growth does matter in the
medium term, inasmuch as indebted households would
have to earn the incomes to meet the interest and
amortisation payments on their debt. If the requisite
increases in income do not materialise, defaults multiply
and this unwinds the boom. It would also have collateral
effects because it impacts on financial agents left
with non-performing debt and assets whose prices are
falling because of excess supplies of confiscated
assets on sale.
The US is an economy that now is experiencing such
a downturn, the full consequences of which are still
unclear. The housing market in the US has been crucial
to sustaining growth in the US ever since the dotcom
bust of 2000. Galloping housing purchases stimulated
residential investment and rising housing asset values
encouraged a consumption splurge, keeping aggregate
investment and consumption growing.
As Chart 1, which provides the quarter-wise annual
rate of change in the combined US House Price Index
shows, the housing market began experiencing a boom
in the middle of 2003, which peaked in mid-2005. Though
housing prices have continued to rise since then,
the annual rate of inflation has consistently declined
(Chart 2). This in itself may be a much needed correction
that should be welcome.
But the downturn is giving cause for concern for two
reasons. First, as mentioned earlier, growth in the
US economy has been sustained by the boom in housing.
Rising house values increases the wealth of home owners
and has a wealth effect that encourages debt-financed
consumption. This drives demand and growth. The housing
boom also pushes up residential investment and construction
which through the demands it generates and the employment
it creates helps accelerate growth. As Chart 3 shows,
these features seem to have played a role during the
current housing cycle as well, though the effect is
more noticeable in the case of residential investment
than consumption, where other factors too must have
played a role.
The second problem lies in the way in which the boom
was triggered and kept going. Housing demand grew
rapidly because of easy access to credit, with even
borrowers with low creditworthiness scores, who would
otherwise be considered incapable of servicing debt,
being drawn into the credit net. These sub-prime borrowers
were offered credit at higher rates of interest, which
were sweetened by special treatment and unusual financing
arrangements-little documentation or mere selfcertification
of income, no or little down payment, extended repayment
periods and structured payment schedules involving
low interest rates in the initial phases which were
"adjustable" and move sharply upwards when
they are "reset" to reflect premia on market
interest rates. All of these encouraged or even tempted
high-risk borrowers to take on loans they could ill
afford, either because they had not fully understood
the repayment burden they were taking on or because
they chose to conceal their actual incomes and take
a bet on building wealth with debt in a market that
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The default risk which was almost inevitable in this
kind of lending, increased sharply when interest rates
rose. The net result has been an increase in defaults
and foreclosures. The Mortgage Bankers Association
has reportedly estimated aggregate housing loan default
at around 5 per cent of the total in the last quarter
of 2006, and defaults on high-risk sub-prime loans
at as much as 14.5 per cent. With a rise in so-called
"delinquency rates", foreclosed homes are
now coming onto the market for sale, threatening a
situation of excess supply that could turn decelerating
house-price inflation into a deflation or decline
in prices. The prospect of such a turn are strong
given estimates by firms like Lehman Brothers that
mortgage defaults could total anywhere between $225
billion and $300 billion during 2007 and 2008.
The first casualties in the crisis have been the mortgage
lenders, who used borrowed capital to finance mortgage
lending. Firms like New Century Financial, WMC Mortgage
and others, which made huge returns during the boom,
expanded lending volumes, encouraged by low interest
rates and slowing house price inflation in 2006. This
required moving into the sub-prime market to find
new borrowers. Estimates vary, but according to one
by Inside Mortgage Finance quoted by the New York
Times, sub-prime loans touched $600 billion in 2006
or 20 per cent of the total as compared with just
5 per cent in 2001. These mortgages reflected very
little own equity of the borrower. According to Bank
of America Securities, loans to sub-prime borrowers
in 2001 covered on average 48 per cent of the value
of the underlying property. This had risen to 82 per
cent by 2006. According to the Financial Times, more
than a third of sub-prime loans in 2006 were for the
full value of the property.
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Mortgage lenders or brokers were encouraged to do
this because they could easily sell their mortgages
to banks and the investment banks in Wall Street to
finance their activity and make a neat profit. And
the investment banks themselves were keen to buy into
the business because of the huge profits that could
be made by "securitising" these mortgages.
Firms such as Lehman Brothers, Bear Stearns, Merrill
Lynch, Morgan Stanley, Deutsche Bank, UBS and others
bought into mortgages, pooled them, packaged them
into securities and sold them for huge fees and commissions.
Numbers released by the Bond Market Association indicate
that mortgaged backed securities issued in 2003 were
at a peak in 2003 when they totalled $3 trillion.
Even though total values have declined since then
because of the deceleration in home price inflation,
they are still close to the $2 trillion mark. Among
the investors in these collateralised debt obligations
(CDOs) are European pension fund and Asian institutional
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With high returns on creating these products and facilitating
trade in them, the investment banks were hardly concerned
with due diligence about the underlying risk associated
with these securities. That risk mattered little to
them since they were transferred to the purchasers
of those securities. The risks in the final analysis
are shared with pension funds and institutional investors
which were buying into these securities, looking for
high returns in an environment of low interest rates.
They are now experiencing a sharp fall in their asset
values and threatened with losses.
In fact the process of securitisation involves many
layers. To quote the Financial Times, the original
mortgages are "sold by specialist mortgage lenders
on to new investors, such as Wall Street banks, who
then use these to issue bonds which are often then
repackaged again as derivatives." According to
that paper, data from the Securities Industry and
Financial Markets Association indicate that more than
$2 trillion of mortgage-backed bonds were sold last
year, of which about a quarter were linked to sub-prime
mortgages. In sum, this whole process, which has at
the bottom home owners faced with foreclosure, is
driven by layers of financial interests looking for
quick profits or high returns. This has transformed
the mortgage securities business. In earlier times,
these securities were bought by investors who held
them till the loans matured and earned their returns
over time. Now these are marked to market and traded.
They are also use to create complex derivatives which
too are marked to market and traded.
The net result is that the housing market crisis threatens
to build into a crisis of sorts in the US financial
sector, resulting in a liquidity crunch that can aggravate
the slowdown and precipitate a recession. All this
has occurred also because of the regulatory forbearance
that has characterised the ostensibly "transparent"
but actually opaque markets that are typical of modern
finance. Investment banks did not reveal the weak
credit base on which the mortgage securities business
was built, investment analysts routinely issued reports
assuaging fears of a meltdown, credit rating agencies
did not downgrade dicey bonds soon enough, and the
market regulators chose to look the other way when
the speculative spiral was built.
But now that the crisis has struck, fingers are being
pointed at others by every segment of the business.
The first fall-person has been the ostensibly deceitful
home owner. "Liar-loans" in which the borrower
does not truthfully declare incomes is blamed by the
business for its crisis. But it takes little to prevent
such activity, if lenders actually want to. The Mortgage
Asset Research Institute, found from an analysis of
100 loans involving self-declared incomes that documents
those borrowers had filed with the IRS showed that
60 per cent of them had inflated their incomes by
more than half. It doesnít take much to demand an
IRS return when making a loan.
The investment banks are of course blaming the mortgage
lenders. Wall Street banks are filing suits to force
mortgage lenders to repurchase loans which they claim
were sold to them based on misleading information.
If a Wall Street bank can be tricked, they donít have
the right to advise investors where to put their money.
And reports have it that those who bought into the
bonds and derivatives these banks peddled are planning
to move court accusing these Wall Street firms of
failures of due diligence.
Finally, the regulators and Congress are sitting up,
as they did after the crash of the late 1990s which
led to the passing of the Sarbanes-Oxley Act. US Congressmen
are threatening to frame a law that restricts the
freedoms investment banks and other financial entities
have when creating bonds and derivatives by repackaging
mortgages to sell them to investors around the world.
But all this is to wake up after the event has transpired.
The "efficient" American financial system
is clearly not geared to preventing a crisis, even
if it proves capable of finding a solution. A solution
that prevents the sub-prime crisis from overwhelming
the mortgage business as a whole, by triggering a
collapse in house prices, is imperative given the
importance of the housing boom in keeping the American
economy going. A slowdown in growth may be manageable.
But a recession can send ripples across the globe.
All this has lessons for countries like India. First,
they should be cautious about resorting to financial
liberalisation that is reshaping their domestic financial
structures in the image of that in the US. That structure
is prone to crisis, as the dotcom bust and the current
crisis illustrates. Second, they should refrain from
over-investing in the doubtful securities that proliferate
in the US. Third, they should opt out of high growth
trajectories driven by debt-financed consumption and
housing spending, since these inevitably involve bringing
risky borrowers into the lending and splurging net.
Finally, they should beware of international financial
institutions and their domestic imitators, who are
importing unsavoury financial practices into the domestic
financial sector. The problem, however, is that they
may have already gone too far with processes of financial
restructuring that have increased fragility on all