The Subprime Saga- What Happened, How, and What to Avoid

The subprime crisis has inarguably been the most talked about issue in this past year, and rightly so. It has changed the face and outlook of the financial world, it has thudded the US economy into depression, whilst other economies flirt with it, or live in fear of it, and it has revised growth estimates for even the fastest-growing economies. While the financial world is still trying to value the subprime loans and ascertain the hit it will have to take, there are lessons to be learnt, more so for us in India. We need to learn, and we need to learn fast, or the growth story may just be a “Once upon a time” fairy tale.

In this post I will begin by explaining the causes of the subprime crisis, as plainly as possible, and then move on to the situation in India. I’ll end with a few suggestions that could prevent a similar situation from occurring in India.

The Subprime Crisis………. What caused it?

A subprime loan is a loan given to those borrowers that are considered ‘high-risk’. The borrowers are typically persons who have had some poor credit history, perhaps in the form of delays or defaults in credit card payments, or any other form of credit defaults or delays. With respect to US standards, these are guys who have a FICO rating of <620.

After the tech bubble burst in 2000, there was a fear that the US would slip into financial depression. In a bid to avoid this, the FED slashed interest rates to facilitate borrowing, in turn leading to economic growth. In time to come, the FED would aggressively cut interest rates as well. The lowest interest rate was a mere 1% p.a.—compared to the current rate of 5.55% p.a. In addition to these measures, the FY 2000 market crash had significantly increased liquidity on account of a flee of funds from the equity markets. Now, an increase in the supply of money also facilitates a reduction in interest rates.

So, interest rates were at an all-time low, and liquidity was very high. Banks and Financial Institutions thus began lending aggressively, which is exactly what the FED wanted. However, a good proportion of the demand was from the subprime class of borrowers, so naturally when banks did lend to them, it was with the pleasing knowledge that the interest rates would be higher for this class of loans. If everything went well, these higher rates would mean an increase in profitability and an increase in the share price. This seemed great, and a little difficult to resist in the prevalent situation.

This increase in money also led to an increased demand for housing, which led to a continuous growth in the market value of these assets (i.e. Real Estate), which was the collateral for the debt. Another angle is that the average American is highly debt-oriented, and resultantly, refinance is fairly commonplace in the US. In order to capture the market, banks began to value these assets higher and higher, as a higher valuation meant a higher loan amount which could enable them to win a deal over competition. This higher valuation also had an impact on the real money-value of the asset.

Let’s take an example: an asset is valued at $100 by the market and the bank, and they decide to fund $80 on this asset. Going forward, banks are willing to fund say $100 on this asset, and as a result the money-value of this asset will eventually increase to re-align itself to the 20% margin.

For the first few years things went well. Interest rates stayed low, the economy continued to grow and the value of real estate assets continued to increase dramatically. This situation made it easy for borrowers to make payments, in case they did run into troubled waters they could top-up their loans, or re-finance their loans at more favorable terms. Now both these mean borrowing to repay previous debts. Such increase in debt is nothing but a debt-trap waiting in the wings. This was, however, a dream run for the banking fraternity. High profits, low defaults. On seeing such profits, banks literally went crazy, offering sub-prime mortgages was the ‘in’ thing and by then a rampant practice.

With high property valuations many borrowers had amassed debts that they could not afford to repay in the long-run. Also, many of these loans came with lower initial payments (step-ups), or initial interest only debt, which made it easier to repay initially. The borrowers thought that since the value of the asset would continue to increase when the low-paying payment ended, they would simply re-finance at better values and favorable interest rates.

Now, the reason for the impact of the crisis being so widespread is because so many banks, firms and investors the world over have exposure to these assets. The toxic credit is simply all over the place, and the reason is securitization. The reason loans were securitized was to diversify the risk and also to free up funds to lend further, banks can only lend a certain multiple of their capital and in order to continue lending they needed to sell down these loans, or put them off-the-books.

So the banks basically clubbed the assets to form pools, the pools were sold to investors and investment banks and called CDOs, MBOs or ABSs. Now, the investors buying these naturally shy away from such poor credit. So the investment banks played it smart and categorized this otherwise toxic credit into 3 different risk levels (also referred to as traunches), and each level is defined by who would take the hit first. These investment banks also got ratings from rating agencies, who rated the lower risk levels at par with quality debt (well above subprime ratings), this was because this was backed by many loans even the other categories. Simply put there guys took the hit last amongst all categories of securities, Now the poorest of the poor loans were obviously not saleable, so a large amount of such instruments were put away into SIVs (Special Investment Vehicles). These are semi-separate off-balance sheet entities, which are basically set up in tax havens, which allow more flexibility from an accounting and regulatory perspective.

These SIVs fund their operations by borrowing short-term at lower rates of interest and invest in long-term instruments. It must be kept in mind that these short-term loans have to be re-borrowed or rolled-over frequently.

It was now 2004, and the problems were beginning. The US economy was growing fast enough. Also, with the new growing economy funds had started flowing back into equities and the money supply had reduced. This led to both the FED increasing interest rates and the supply reduction leading to an increase in rates. As a result, re-financing became uneconomical. Since most of these rates were on an annual reset, the interest rates increased, leading to a difficulty in meeting finance commitments. As loans became more expensive, the demand for housing reduced, leading to a reduction in the value of the asset. Now this led to a chaotic situation, where borrowers began to default on their loans at an alarming rate. The investing institutions who held the securities backed by this debt stood to loose.

All this led to two things: a liquidity crisis, and mass mistrust in other financial institutions, which reduced lending amongst various financial entities. This further impacted the liquidity in the market.

The market situation is such that no one trusts anyone enough to lend money at reasonable rates. No one knows who is stuck deep in how much toxic credit. The largest banks and financial firms have been trying to ascertain and value their assets for a few months now and are still unable to do so accurately. The SIVs now are unable to avail of funds to cover their obligations and are therefore having to sell off huge chunks of toxic credit which has no market.

Importantly, since there is now virtually no market for the toxic credit pools, it is difficult to ascertain how much it is worth. Thus it’s impossible to ascertain how much of a loss one needs to make provision for in order to come off clean.

All in all, banks and firms will need to take significant hits, which may be painful now, but from a long-term perspective it’s the only solution. No pain, no gain.

Now, coming to the lessons
There is no substitute for quality underwriting and the faster lenders realize this the better it will be. Business cycles are just business, there will be the not-so-good and even the ugly times, and while lending it is critical to understand this.

Growth rates sound lucrative, but these are only projections. It’s important to remember that when the base expands growing on this higher base is more difficult. So a lender needs to critically examine if the borrower has the strength to expand his business in that way, weather he has the execution capability and the team to manage such an enlarged business and whether he has the flexibility to sail across rough waters when they are encountered.

It’s critical to understand that a default situation besides being bad for the company and the bank is extremely hazardous to the economy at large. Bailment like the FED’s bailing out of Bear Sterns may sound good but the impact is, in reality, quite hazardous.

Now coming to the Indian perspective:
Banks and FIs in India in order to grow at staggering rates are lending extremely casually, this on the backing of an aggressive growth story. Deviations from such estimated growth rates may lead borrowers into troubled waters. It’s important that we lend only after quality due-diligence.

Another important fact is that we need to keep customers informed, and transparency is critical. Only recently there was a big hue and cry when customers figured out that their home loans in India were reset when rates increased. The problem was that customers were not informed or explained to about the fact that their loans were on floating rates.

Besides as an investor one needs to understand the investment very well and be able to make an informed investment decision. This is something that was completely missing in the subprime saga. Besides, many investors took huge hits in India, only recently, while investing in exotic options that they were not well informed about. This has also led to litigation between the sellers of the investment product and the investors. Such practices will do nothing but reduce confidence in the system.

Remember, we had parked the FICO rating in the first part of this article. In that light it is important that in India we move to an individual and company rating system. This will lead to better information symmetry between lenders and will do only good to the industry and the economy.

Finally, the last point is the need for proper governance, requiring more elaborate reporting by banks and adequate categorization of assets and investments. Cross-holdings need to be depicted properly and assets valued correctly. Conduits, if any, must be disclosed accurately along with any indirect credit lines that may exist.

It’s the greed to grow faster than a natural rate that hampered the US and will hamper any economy. The big avoids remain ignorance, greed and purely stupid bets.

To conclude:
“No drug, not even alcohol, causes the fundamental ills of society. If we're looking for the source of our troubles, we shouldn't test people for drugs, we should test them for stupidity, ignorance, greed and love of power.” - P. J. O'Rourke

-Puneet Gulwani