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The Subprime Crisis A Post Mortem

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					The Subprime Crisis - A Post Mortem. The story begins a not-so-long time ago, in a land far, far away..... As a matter of fact, I have no doubt that most of my readers are already well aware of what the sub-prime crisis is, and what its effects could be. The purpose of this article is to provide a nutshell version of the events that lead up to the crisis, and a few comments therewith. In the United States of America, the years following the bursting of the technology industry bubble in 2000 were marked by very low interest rates. The Federal Reserve reduced the rates in order to stave off a potential recession and encourage business growth. Eventually, this created an excess of liquidity in the economy, and many banks, flush with funds, began to take greater risks in order to get greater returns. One of the directions taken by this behavior was the granting of housing loans to individuals who had a comparatively high risk of defaulting on the loan repayments. There was ample incentive for the banks to do this, since they could charge a higher interest rate for these loans. The added incentive and safety net was the steady increase in house prices which made it possible for these borrowers to re-mortgage their houses at more favorable rates and for the bankers to view foreclosure as a not necessarily undesirable outcome. Many banks moved very heavily into the subprime mortgage market during this period. Traditional banking practice limits the amount of money any bank gives out as loans to a fraction of the amount of money it holds in deposits from its customers. However, modern financial "engineering" removes these limits, and allows banks to approve loans worth a far higher amount. Banks bundled together several loans and sold them to other investors as Mortgage Backed Securities or Collateralized Debt Obligations. This allowed them to obtain more money to make even more subprime loans. Once a number of loans were bundled together, this bundle was again sliced into different "traunches" by the financial wizards. A high ranking traunch was one which would be the last to take losses if the mortgage payments were to default. The lower ranking traunches would take the losses first. As usual, the higher ranking tranuches paid lower interest rates than the lower ranking ones. The thing that one should bear in mind is that all the loans in the bundle are still more likely to default than usual. However, this distinction allowed the banks to get credit ratings from high to low on the range of traunches. Many organizations, with the tacit approval of the credit rating industry, ignored the truth that the best of a bad lot isn't really a great deal and purchased these traunches with reckless abandon. Those that were restrained from directly purchasing these toxic assets resorted to creating special purpose off balance sheet investment companies to do just that. Again, many of the organizations which purchased these securities insured themselves against the risk of default. However, when we remove all the jargon associated with it, insurance is just an attempt to reduce the damage caused by a single failure by spreading the risk of failure over a lot of attempts, under the assumption that there will be significantly more successes than failures. If, however, there is systemic failure, then the damage is inevitable and the insurers will have to face the music. Problems were bound to arise, as they most emphatically did, when any of the assumptions in this model failed. The Federal Reserve, in accordance with its policy of stabilizing the economy by adjusting interest rates, started increasing the rates again since the danger of recession appeared to be over. By 2007, the rates had increased from 1% to 5.25%, and many people could

not afford the mortgage payments that this would entail if they were to purchase a house. The demand for housing started to decline and house prices followed the downward spiral, laying waste to the basic assumption that the housing market could only go up. Many of the subprime borrowers found it increasingly difficult and finally impossible to make their mortgage payments. The value of the houses fell significantly below the value of the loans used to purchase them, rendering even foreclosure an unattractive option. Many large subprime lender companies started to fail as their customers began defaulting on loans. The market for the "bundles of loans", or the Mortgage Backed Securities, was valued at a few trillion dollars in 2007. Suddenly, nobody wanted to buy these securities any more, because their chances of default had increased dramatically. If a class of assets that was worth trillions of dollars one day, and is suddenly completely worthless the next, it doesn't take much intelligence to suspect that there is a very very serious problem afoot. Events came full circle, as banks could not raise capital in this manner any more. Indeed, owners of these securities faced massive losses - and no one knew how much any given bank had invested in these Mortgage Backed Securities. Banks started refusing loans to each other, freezing the financial system and causing further chaos. Insurers faced the prospect of being unable to honor their commitments, and called for government intervention. Most reputable analysts now think that the world economy faces a significant chance of recession in the coming year. How does all of this affect us here in Dubai? Firstly, almost all international banks have some level of exposure to the subprime crisis. Naturally their operations in the Middle East will be impacted, depending on the size of their exposure. Liquidity will go down, and only strong projects and operations will survive. Speculators who are already invested in the markets will face difficult times. Secondly, a correction is not necessarily a bad thing. It was bound to happen in any case, since the levels of growth we have witnessed over the past few years are not sustainable in the long run. A correction in time will prevent a worse crisis tomorrow. The flip side of the coin is increased stability, reduced inflation, and a sensible housing market. Thirdly, most reliable sources tend to predict that while a slowdown is inevitable, an actual recession in the gulf region is quite unlikely. In fact, the gulf region is considered to be among the safest places worldwide to shelter from the economic storm impending. The past few years of strong growth have given us a very solid foundation on which to build. The expansion plans are supported wholeheartedly by the rulers in most gulf countries, and especially so in the UAE. The best international talent is available locally to counter developments in a strategic and timely fashion. The central bank interventions are ample evidence of an alert and careful government. That said, it would be unwise to expect a continuation of the boom times of yesterday: the gulf will necessarily be impacted by the decline of the world economy. I shall wind up today's column with the following nugget: The word subprime itself is not well understood. Type it into any word processor program, and it will be underlined in squiggly red. A sub-prime loan can be defined as a loan made to a person who has a higher than usual chance of defaulting on the payments. However, it is as much a matter of fact that almost all micro-financing schemes are in fact examples of sub-prime lending. And also that micro financing has catapulted several million individuals out of poverty and into a comfortable middle class lifestyle. There are two sides to every story; let us hold on tight, and wait for the whole tale to be told.


				
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posted:1/21/2010
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Description: Article on the Sub Prime Crisis published in the Business Quality Review Magazine