What is US sub-prime crisis all about?

The mini-financial crisis in the sub-prime lending in US might not have been comparable in proportion to the accounting scandals of the past. But in terms of impact-both on the US and the world economy-the crisis does not seem to be less daunting. Tremors caused by this crisis have already hit the capital markets world-wide. Banks having large exposure to US debt are also in trouble. And for all that is being reported in the press, the crisis is not likely go away in a hurry, not withstanding the cut in federal rate and other possible measures.The manifestation of the crisis can be traced to some very imprudent and reckless banking practices in the US. A significant section of the American population is out side the realm of getting a housing loan due to its lower repaying capacity. Sub-prime lending (ie, lending at higher interest rates) by some banks and financial institutions was seen as some sort of a financial ‘innovation’ that could go a long way in helping the Americans with mortgage loans. Now, as per the reports appearing in the financial press, these institutions have gone over board and lent loans recklessly to almost every body who wanted such a loan.

Typical of the way things happen in US unlike in most of Europe and elsewhere in the world, these institutions have not stopped at that. They have packaged them in to fancy derivatives and debt and sold them to hedge funds. The financial complexity and indirect funding has only postponed the inevitable. In contrast, in EU, banks and financial institutions keep their loans in their books only and do not sell as derivatives or debt. Almost the same is true in case of India, too.

Therefore sub-prime crisis has landed these institutions in to financial mess; but they have also dragged hedge, even pension funds in to the crisis. This is what is worrying the US authorities more than anything else. In retrospect, the sub-prime crisis was waiting to happen. What with high interest rates on the one hand and a large clientele of dubious distinction on the other, this was only expected.

As the repayment crisis has hit the banks, about $ 25 billion of sub-prime loans are being re-priced now. But at the rate of around $30 to $45 billion, this figure is very likely to cross the $ 180 billion mark. Next year, readjustment will be required in respect of loans worth $400 billion! In order to cover increased risk, banks will raise the lending rates. Though the fed may lower the rates, customers will be hit hard. This is likely to aggravate the problem, with more people unable to repay their loans in time.

Besides the stock market, how the US crisis will hit the Asian, more specifically Indian, GDP rates are a matter of speculation. There would be a time lag before the effect actually can be assessed. Global liquidity might become tight; the bigger corporates may feel the pinch of higher rates abroad. The US economy may slow down as a result of this crisis.

Though it is safe to assume that the world economy will therefore be hit, the impact may not be the same on all nations. In fact, in financial turbulence, the US may look for cheaper imports from China and other countries. Domestic economies in these countries are in robust shape; they have also reduced their excessive dependence on US or EU in course of time. Most importantly, nearly all of them are sitting over a pile of foreign exchange, which will help them to weather any gathering storm.

So, no point blaming globalisation for transmitting crises of this type; it has also facilitated nations to become stronger and face problems with confidence like never before. But the banking industry has lessons in the entire episode. Old, prudent and conservative banking principles still hold good and following them steadfastly all the times is absolutely imperative.

By D M Deshpande

The Real Causes of the Financial Storm

PARIS -- "Tornadoes are caused by trailer parks." Norm Augustine, former chief executive of Lockheed Martin, coined that aphorism a few years ago after seeing one too many photos of mobile homes that had been devastated by twisters.

A similar misapplication of logic is now evident in discussions of the economic havoc surrounding subprime mortgages. These flimsy loan structures have been splintered by a financial tornado, but they were not the cause of the storm. For that you have to look deeper into the financial system, to the regular pattern of bubbles and binges that has been evident during the past several decades.

A useful compilation of these recurring crises appeared in the Financial Times last week in an article by former Treasury secretary Lawrence Summers. He cited the 1987 stock market crash driven by lockstep "pattern trading"; the rise and sudden collapse of savings and loan institutions in the late 1980s; the frantic borrowing by Mexico that spawned the 1994 peso crisis; the lending binge that led to the 1997 Asian financial crisis; the Russian debt default of August 1998 and the ensuing demise of Long-Term Capital Management; the technology bubble of the 1990s that burst in 2000; and the deflation worries that followed the collapse of Enron in 2002.

These disparate crises share a feature: In each case, capital flooded into assets that were thought to offer higher returns -- only to flood back out when the assets proved to be shaky. Investors overlooked the ordinary risk factors in their hunt for extraordinary profits. Rather than contenting themselves with the average "beta" returns of, say, the Standard and Poor's 500, they sought what a magazine for hedge fund managers last year described as "portable alpha." They were seeking a world like the one at Garrison Keillor's mythical Lake Wobegon, where all the children are above average.

Subprime mortgages are the latest example of the financial world's relentless push for higher yields. As has been widely noted, the term "subprime" was a euphemism for loans that did not meet traditional standards of creditworthiness. The financial wizards believed that by combining these mortgages into large pools that could be turned into securities and then dicing them into pieces that allowed investors to choose their desired level of risk, they could vitiate the underlying problems. A big basket of uncreditworthy loans, in other words, was thought to be safer than the individual loans themselves.

Wiser heads kept warning about the potential for disaster in this "appetite for risk," as the Bank for International Settlements described it in its annual report last summer. But financial bubbles must be lived forward, even if they can be understood only in reverse.

The crackup finally came this summer, as worries spread about the extent of losses from subprime loans and panicky financial institutions rushed to dump anything that might be contaminated. Just as capital knows no borders, neither does fear. The global race for the exit became so frantic that central bankers grew concerned that the payments system wouldn't be able to accommodate all the traffic and would freeze up in a classic financial panic. So the Federal Reserve led a rescue effort, pumping in hundreds of billions of dollars in liquidity and announcing a surprise cut in the discount rate.

People looking at this crisis in isolation expressed relief that the Fed bailout seemed to have worked. But I find greater cause for worry. What we are seeing is a financial addiction -- to ever-more exotic classes of high-yielding assets to tempt global investors and then to the Fed's infusion of liquidity to keep the system from self-destruction. The financial world, you might say, is addicted both to the heroin of high yields and the methadone of the Fed's rehab program.

Investment guru Warren Buffett has been warning for years about the dangers of derivatives -- the complex financial instruments that undergird modern capital markets. The problem is that derivatives, with their interlocking contracts that are often little understood even by financiers, bind the elements of the global system together while obscuring the weakness of the individual pieces. What happened in August's panic was partly that nobody in the markets could be sure how bad the subprime fallout would be, because it was obscured by all the swaps and hedge contracts. The French bank BNP Paribas sent the panic into overdrive when it suspended trading in three of its funds because it couldn't value their losses.

The Fed can keep rescuing the financial markets by providing emergency liquidity to rebuild the flimsy trailer parks. But it's time to look at the tornado itself -- the immense unregulated flows of capital and the new financial instruments that give them such devastating velocity.

By David Ignatius

http://www.washingtonpost.com