Asset price increases of property not sustainable

The article by Mr.S.Gurumurthy in Businessline provides an excellent analysis for the reasons behind the so-called sub-prime crisis in USA. While the parallels between USA and India end there, the likelihood of a sub-prime crisis in India is a bit remote. Except a few banks, which have agressively lent resources in the last three years to garner market share, most of the banks are safe as regards to lending to the housing finance market. While, the NPAs on account of housing finance might be higher compared to the previous years, prudent players such as HDFC have taken lead to cut lending rates to both existing and new customers for housing loans by 0.25% basis points.

Sub-prime: An American loan mela at global cost
S. GURUMURTHY
The US financial system consciously pushed sub-prime loans to put cash in the hands of gullible and non-creditworthy borrowers and make them splurge at shopping malls, so that wealth shifted from families to corporates. And when things fell apart, it was also at the cost of the global community, says S. GURUMURTHY
After the ‘Shop-for-America’ call in 2001, sub-prime mortgage lending almost ceased to be commercial lending. It became, in Indian etymological terms, an American national loan mela, though somewhat sophisticated. In substance, it was no different from the social loan melas regularly held here in India in the 1980s by ministers in charge of nationalised banking. But there are differences between the Indian and American melas.
The Indian loan mela was essentially swadeshi. The American, like everything connected to the US, is global! Moreover, the Indian mela was smaller in size, indigenously funded. In contrast, the American mela size is in trillions of dollars, much of it funded globally. So the US loan mela is global in its impact; consequently it is in global discourse.
The Indian loan mela, poorly packaged, was condemned as squandering of public funds. But the American loan mela is presented as a strategic and sophisticated plan by the US Fed to promote supply-side economics and overcome recession! Of course, many concede now that somewhere it went wrong. But it was not wrong in itself. Now on to the story proper.
With massive campaigns by select interests exhorting Americans to shop for America and creating favourable conditions for the same, the US Fed and the US financial system consciously launched the sub-prime loan mela to put cash in the hands of Americans to make them to do their patriotic duty in the malls.
Thus were opened the floodgates of sub-prime lending in the year 2001. Further, the bundling and selling of mortgages through Mortgage Backed Securities (MBS) and the emergence of mortgage bond market made it easy for the sub-prime loan mela to be scaled up massively. This needs some detailing.Passing the buck
With the intervention of MBS, housing loans ceased to be a bilateral affair between the mortgage lender and the home buyer. In the past mortgage lenders, mainly banks, used their own deposit funds to invest in housing mortgages. The deal was bilateral. The bank would grant the home-buyer mortgage loan and the latter would repay the mortgage debt to the bank. The banks financed mortgage loans out of the deposits from the public. Since it was their own money, the credit check was understandably rigorous and the volume of credit necessarily limited. The banks did the income check on the borrower and a valuation check on the properties. But, in the last two decades, the mortgage lenders began securitising their mortgages in bulk and sold them as MBS bonds to pension funds, insurance companies and other private investors within and outside US.
Thus the initial lenders passed the buck on to bond-holders. The result: the ultimate lenders, who invested the gullible investors’ money, did not know the ultimate use or users of the funds and trusted a whole lot of intermediaries linked sequentially — the lenders, the mortgage brokers, valuers, rating agencies, legal and accounting firms, those entering and exiting the bond market — to invest or keep invested in the MBS bonds.
With such developments, US and global private players entered the US house financing market in a big way. And with the US Fed making credit available at almost no interest, it became an issue of finding borrowers who would sign loan bonds, take the money and go to malls. So, thousands of mortgage brokers were appointed to look for gullible borrowers to thrust homes and loans on them. They indeed brought in over 5 million sub-prime borrowers in as many years.
Thus the results of US housing loan mela were instant. The data tells all. Home ownership in US, which had stagnated at around 64 per cent from 1980 for nearly two decades, rose to 69.2 per cent in 2004, the highest ever.
Home prices rose by 126 per cent between 1997 and 2006. Initially, it was the dotcom bubble that set off the demand in the housing market. But, when the dotcom bubble burst, the loan mela set off by the call to ‘Shop for America’ sustained the housing bubble.
The appreciation in home values became an avenue to lend against such appreciation. Thus it became a case not of borrowing to buy houses, but borrowing on houses for buying something else — cars, jewellery, and all else. What does that mean? Not to buy homes
Housing loans ceased to be for buying houses. This is where sub-prime lending took the shape of a loan mela. Sub-prime mortgages took various forms. They represented monies lent to persons with poor credit histories. There were other models of financial engineering of MBS which, if taken together the non-prime lending, along with the sub-prime lending, top $2.2 trillion.
The establishment’s intent in driving sub-prime and non-prime lending was clear. Cash should be put into the hands of anyone willing to sign a debt bond, so that the malls sold their goods and wealth shifted from families to corporates. The sub-prime mortgage loans increased from $190 billion in 1999 to $1.3 trillion in 2006. The sub-prime mortgages that originated in just two years, 2005 and 2006, alone exceeded $1.2 trillion (New York Times, July 27, 2007).
With low interest rates and high liquidity in the market, the interest differential between prime and sub-prime loans drastically narrowed — from 2.8 per cent in 2001 to 1.3 per cent in 2007. The share of securitised sub-prime mortgages increased from 54 per cent in 2001 to 75 per cent in 2006.
But see how the credit check was done under the securitisation scheme, as compared with bilateral lending. The mortgage underwriting, which determined whether the risk of lending to a particular borrower was acceptable, was automated — yes, automated! And by 2007, 40 per cent of all sub-prime loans were generated by automated underwriting checks!
An official of a home-loan company gleefully said: “Prior to the automation process, getting an answer from an underwriter took up to a week. Now we are able to produce a decision under 30 seconds.”
What did the banker who originated the sub-prime lending do? He was looking at the number of mortgages he originated, as the number determined the hefty fee charged and got. So the number and not the quality of the mortgage became an issue for the originating bank. Rating agencies
If underwriting was automated and the bank became more concerned about the number of mortgages that settled its fee, how did the three credit rating agencies, Moody’s Investor Service, Standard &Poor and Fitch Ratings, fare? The rating agencies were supposed to rate the MBS for use by the investor. Instead, they rated them at the instance of the issuer.
Said the NYT (of July 27, 2007): “The three rating agencies actively advise the issuers of these securities on how to achieve the desired ratings. They appear to be helping the investment banks, hedge funds, and other fund companies, all of which have fiduciary obligations to the investors, to develop the worst possible product that still achieves a certain rating.”
But what happened to these ratings when housing prices began to move southwards in 2006? The triple-A rated CDOs fell by 20 per cent; the Double-A rated ones fell by 66 per cent; A-rated ones fell by 75 per cent; triple-B and double-B rated ones fell by 80 per cent. (BBC News, November 27, 2007). Today, the issuers say they went by rating agencies; the rating agencies say they trusted the data provided by the issuers.
The rated CDOs are today orphans with no one to own them! It is not just American money that is lost. Many foreign investors, the Swiss bank, UBS for instance, had put money in CDOs.
They have to write them off today. UBS had already written off $13.5 billion in the third quarter. Yes the American sub-prime loan mela is truly global, at the cost of the global community.
Tailpiece: There are many here who want the American system of home loan based on MBS, and with the entire complement of global funds, fund providers, brokers, rating agents, lawyers and accountants imported from abroad, instituted here. And they want the Indian stamp and property transfer laws to be amended to make that model work here. Will their enthusiasm remain the same after the US experience? Or would they still like to experiment with the US model in India?
(Concluded)