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					Comment                                                        19 December 2007

By Invitation: Prof PDF Strydom


           THE SUBPRIME MORTGAGE MARKET CORRECTION∗

The subprime mortgage market in the US refers to that segment of the financial
market where mortgage credit is granted to borrowers with a poor credit history. The
expansion of this market during recent years in the US is due to three reasons. The
first is an expansion in fraudulent transactions where lenders submitted false
documentation on their income and employment condition that enabled them to
acquire mortgage loans. The second reason is that lenders were encouraged to
accommodate these risky customers because of the boom in the housing market.
Some of these borrowers were financially not in a position to repay the principal
capital amount while others qualified for paying the interest charges over the short
term. The expectation of making a quick profit by selling the asset at a capital gain
was severely disappointed when the housing market reached its peak and prices
started a declining phase. Borrowers were left with assets that they could only sell at
the ruling market price by incurring a loss. Lenders were left with loans that could not
be serviced and with no hope of recovering the principal capital outlay on the
underlying asset. The failure rate on subprime loans has risen markedly on loans
granted over the past two years. Goldman Sachs estimated the total loss on these
loans to amount to approximately 22% of the subprime mortgage loans made during
2006-2007. Thirdly, subprime lending escalated because banks have adopted a new
business model that enabled them to extend their credit creating activities at lower
cost. Unfortunately the new model did not impose the same discipline on bank
managers regarding credit quality ratings and prudent behaviour.

The boom in the US housing market was fueled by relatively low long-term interest
rates. These relatively low rates were the result of international imbalances in the
sense that the global economy experienced large saving surpluses in the EU, oil
producing countries, Japan and emerging market countries, particularly in Asia.
These imbalances were accompanied by current account surpluses in saving surplus
countries and current account deficits in saving deficit countries of which the US was
the most prominent example. Saving surplus countries invested heavily in US
financial assets. This contributed towards increased liquidity in financial markets with
downward pressure on US long-term interest rates. These relatively low long-term
interest rates in the US were reluctant to follow the upward pattern in short-term rates
when the US Federal Reserve Bank started raising short-term interest rates in
2004/05. Long-term US rates started falling and the spread between long and short-
term rates widened. This resulted in what the Chairman of the Fed at the time, Allan
Greenspan, described as a conundrum.

1. The new business model

In terms of the conventional business model banks acted as financial intermediaries
in the money and capital markets. In this framework banks took deposits to finance
their lending book while they were responsible for the quality of their assets and
liabilities as displayed in the balance sheet.     Moreover, banks continuously

∗
 Paper delivered at the Ruiterbos Colloquium 21 November 2007. The author gratefully
acknowledges contributions made by colloquium participants on an earlier draft.


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scrutinized the quality of the asset side of their balance sheet. By doing so they
secured the confidence of depositors that supplied them with reliable liabilities.
Following the deregulation of the financial sector and the development of markets for
asset-backed tradable claims the banks gradually changed to a new business model.
In this new environment securitisation featured prominently as banks transformed
pools of loans into different assets with varying degrees of risk. Low risk financial
assets were sold to market participants, such as pension funds, that favoured
investment in quality assets. High risk assets were sold to banks and hedge funds.
In this way banks opened up new credit creation opportunities because their balance
sheets no longer carried the obligation of the original credit transaction. In terms of
the old business model this was known as disintermediation, i.e. credit was created
off balance sheet. In the new model the banks’ obligations were taken onto the
balance sheet but at a later stage removed through securitisation. Although the
process is different from the old model the outcome is equivalent to
disintermediation. This practice developed into a sophisticated process in terms of
which banks packaged loans into securities that were sold to other financial
institutions. These packages included mortgage debt and more importantly for our
exposition, subprime loans. Financial institutions repackaged these securities
together with other debts into collateralized debt obligations (CDO’s). Moreover,
banks created so called structured investment vehicles (SIV’s), also referred to as
conduits, to assist these off balance sheet credit activities. Packaged debts were
passed on in securities to SIV’s and banks thereby released space on their balance
sheets to create new credit.

Credit expansion went hand in hand with lower credit cost but the risk factor to the
banks increased. In some instances banks were making poor lending decisions. In
other instances subprime lending was not conducted by banks but by brokers and
financial mediators. The discipline coming from depositors in the old business model
was watered down significantly in the new model. In the old model there was a direct
link between deposits and lending behaviour as conducted by the old building
societies. In the new model bank funding shifted to the wholesale market in a similar
way as Merchant banks. Unfortunately, certain classes of securities comprising
CDO’s were hardly or never traded. The values of these instruments were computed
by complicated mathematical procedures and the computed values were readily
accepted within the financial sector. The general attitude was that securitisation
reduced the credit risk to banks and that high risk credit transactions were securitised
and passed on to institutions that were geared to take on higher risk that carried a
higher yield, such as hedge funds. This exposition shows how the subprime
mortgage market, that is a relatively small fraction of the mortgage market, became
linked up to many financial institutions. Moreover, many of these securitised
packages were sold on international markets, involving banks in the UK, Germany,
France and Japan. Gradually this house of cards developed into an accident waiting
to happen. The financial system was set to experience a major institutional failure.

2. The credit crunch

Subprime mortgage defaults started to emerge and gained momentum as the
property market (housing market) in the US showed signs of collapsing. House
prices peaked and started the falling phase of the cycle. Market participants were
trying to reduce their risk exposure and credit spreads between high and low risk
instruments widened. As indicated above, elements of the packaged securities were
never traded and for the purpose of ordinary financial deals, the valuation of these
assets was determined through complicated calculations done by computers. In a
world of widening credit spreads and a rising sensitivity towards risk these computed
values had little market appeal. The marketability of these instruments was


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vanishing. With limited opportunities of selling the securitised debt the SIV’s started
experiencing liquidity problems and the banks were forced to assist their own
institutions. As can be expected liquidity in the money market was drained away with
devastating effects on credit spreads. Banks became reluctant to lend money on the
interbank market because the exposure of banks to SIV’s was unknown and not
transparent. As indicated above, these SIV’s were sitting on securitised debt that
could not be traded in the market. Certain debt markets became closed. These
developments converged into a credit crunch. The ECB started supplying liquidity to
the money market in order to reinstate the flow of funds in the interbank market.
These actions were supported by the US Federal Reserve Bank as well as central
banks in Canada, Sweden and Japan. The widening spread between money market
rates and the Fed’s policy target rate encouraged the US central bank to reduce its
discount rate followed by reductions in the Fed funds rate.

3. The banking crisis

These policy measures relieved the pressure on the money and interbank market but
despite the recovery in the flow of funds a banking crisis emerged. This occurred
because of a feature of the new business model that can be described as
reintermediation. This refers to the process whereby high risk debt that was removed
from banks’ balance sheets through securitisation re-emerged on balance sheets as
banks were obliged to accept them. In the final analysis they were linked to debt
that originated with banks. Loss making credit transactions that were off balance
sheet re-emerged on the balance sheet and the funding of banks through the
wholesale market collapsed because, as indicated above, these assets were
characterised by low or zero marketability.

The banking crisis deepened as banks started reporting large losses while they
experienced difficulty in securing retail deposits owing to a breakdown in the public’s
trust. In the UK clients queued outside Northern Rock bank to demand their deposits
in cash. The run on the bank eased as the UK government secured bank deposits.

The phenomenon of reintermediation changed the perceptions regarding credit risk
and encouraged a reassessment of securitisation. The value of quoted bank shares
on the stock exchange, particularly in New York, fell sharply. Market participants
gradually realised that they were unable to determine the extent of the damaging
effects of the subprime mortgage correction on the financial sector. Banks started
producing estimates of their expected losses that were to be written off but within
days estimates changed into staggering numbers during the scheduled third quarter
reporting period in 2007.

The authorities extended their intervention in the financial sector to secure stability.
Intervention required extraordinary judgmental skills to distinguish between bona fide
lender of last resort actions aimed at protecting the financial system as opposed to
bailing out bad credit transactions. The latter would encourage the so-called moral
hazard whereas the first requires accommodation of eligible credit instruments at
penalty rates.

The revision of the regulatory procedures is clearly an imperative. The fragmented
and decentralised regulatory system of the US has now proved its inefficiency in
securing sound financial practices. It is certainly scheduled for a substantial overhaul.
A similar conclusion applies to the UK regulatory framework. The regulatory system
in the UK, created by the present government, is crying out for substantial revision. In
terms of this system the Bank of England is only responsible for systemic risk. It
goes without saying that deposit insurance is also scheduled for review, particularly


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in view of the Northern Rock experience. The South African regulatory framework is
less fragmented than those referred to above while the Reserve Bank is conducting
bank supervision as opposed to independent authorities in the US and the UK. The
important lessons regarding the regulatory procedures are that the central bank
should be responsible for systemic risk as well as prudential behaviour by the
financial sector as a whole. The central bank cannot be expected to operate as
lender of last resort without controlling these two areas for the financial sector in total.
Owing to the corporate linkages between banks and other institutions this control
should cover all financial institutions. The Financial Services Authority should
concentrate on corporate governance and other aspects regarding the conduct of
business in the financial sector.

4. Summary and conclusion

The subprime mortgage correction in the US can be described as a major
institutional failure in the financial sector. The effects on the financial as well as the
real sector are far reaching. They are unlikely to be of a short-term nature and the
world will have to prepare itself for the full effect of the correction over a number of
years. The correction will have a global growth inhibiting effect but this will be more
evident in the US, particularly in 2007 and 2008. The extent of this is still uncertain
but the downward direction in economic growth is already becoming evident. In this
respect the well-known relation between the real and monetary sectors as described
by the old quantity theory of money appears to be constructive: MV=PT.

The banking sector has made substantial progress in applying the new business
model but there are many procedures that have to be changed. Transparency
regarding the assets to be securitised is imperative. The importance of trust in
conducting financial transactions that featured prominently in the old business model
has to be reinstated in the new. Securities that are associated with debt that cannot
be effectively valued by market participants should not be included in CDO’s and
should probably remain on the balance sheet of a bank where it could be identified
through financial reporting. The subprime correction has revealed the extensive
international linkages between financial institutions. This emphasises the importance
of institutional efficiency. A revision of the regulatory procedures is therefore an
imperative. In similar vein one could add that the models that rating agencies apply
in assessing the quality of assets and portfolios rely too heavily on historical data and
they appear to be ineffective within the dynamic framework of securitisation. The
subprime correction has given a new meaning to market volatility in the sense that
volatility signals uncertainty amongst market participants regarding their ability to
price debt instruments effectively.

REFERENCES

Arturo, E. 2002 Securitization and the Efficacy of Monetary Policy, Federal Reserve
      Bank of New York, Economic Policy Review, 8(1).
Bernanke, B.S. 2007 Housing, Housing Finance and Monetary Policy, Federal
      Reserve Bank of Kansas City, Jackson Hole conference.
Bruggemans, C. 2007 Reckless Lending with a Difference, FNB Subscriptions,
      www.fnb.co.za/economics.
Feldstein, M. 2007 Housing, Housing Finance, and Monetary Policy, Federal
      Reserve Bank of Kansas City, Jackson Hole conference
Masters, B and Scholtes, S. 2007 US Seeks Culprits for Subprime, London Financial
      Times, 8 August, www.ft.com.
Rogoff, K. 2007 The Fed v the Financiers, www.economistview.typepad.com
Scholtes, S. 2007 On Wall Street: Out of Frying Pan but Fire Sale is On, London


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      Finacial Times, 19 October, www.ft.com.
Tett, G. 2007 Regulators Rethink Bank Rules, London Financial Times, 19
       September, www.ft.com.
Tett, G. 2007 Draining Away: Four Problems that Could Beset Debt Markets for
      Years, London Financial Times, 27 November, www.ft.com.

Tett, G. and Davis, P. What’s the Damage? Why Banks are Only Starting to Uncover
       the Subprime Losses, London Financial Times 4 November, www.ft.com.
Wolf, M. 2007 The Bank Loses a Game of Chicken, London Financial Times, 20
       September, www.ft.com.




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