How and when did the sub-prime mortgage crisis begin?

Charity begins at home, it is said. Here, crisis began at home, or more exactly, home loans. Housing prices began spiralling upwards in the US in the early years of this decade and continued through mid-2006, with the borrowing and lending rates extremely low which helped boost the demand for and supply of new and existing houses.

Many institutions offered home loans to borrowers with poor or no credit histories by requiring higher than normal repayment levels — creating what is now referred to as “sub-prime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy.

When did the slide begin?

A retrospect does help when the market is in a crisis. The countdown began on June 30, 2004, when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels registered since the 1950s.

It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.25 per cent.

The US housing market began sliding in August 2005 and that continued through 2006. Building rates and housing prices tumbled.

Did this cause business failure?

Yes. Several sub-prime mortgage holders defaulted on their loans and the first sign of a “crisis” emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy.

Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7 billions of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans.

What do you think was the spillover effect of the slide?

The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares in Bear Stearns came under pressure in May 2007 because of the bank’s exposure to the US sub-prime market. In June, Merrill Lynch seized and sold $800 millions of bonds used as collateral for loans made to Bear Stearns’ hedge funds that were used to bet on the sub-prime mortgage market.

In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge funds hit by the defaulting sub-prime mortgages.

Can you give us a timeline of the recent events?

Given the dominance of US financial markets in other developed and developing economies, the sub-prime mortgage market crisis affected markets and institutions all over the globe.

On July 27, 2007, worries about the sub-prime crisis hit global stock markets and the main Dow Jones stock index lost 4.2 per cent in five sessions — its worst weekly decline in five years. The fall continued in August.

On August 3, 2007, the Dow Jones Index ended the session almost 2.1 per cent lower. The same day, London’s main FTSE 100 stock index closed down 1.2 per cent with French and German markets also declining. On August 9, French bank BNP Paribas suspended three investment funds worth €2 billion citing problems in the US sub-prime mortgage sector.

The Dutch bank NIBC announced losses of €137 million from asset-backed securities in the first half of this year.

The European Central Bank (ECB) pumped €95 billion into the European banking market to allay fears about a sub-prime credit crunch.

What has the US sub-prime market crisis got to do with stock markets going haywire in India?

The Indian stock markets have also witnessed mammoth losses in the recent past and investors are left wondering whether the impact is linked to the contagious impact of the US sub-prime market crisis.

The SEBI (Securities and Exchange Board of India) Chairman, Mr M. Damodaran, said:

“He will be a bold man who assumes that stock prices are a resultant of one single factor. At the end of the day the price of a stock is determined by the demand and supply of that stock … A fall in the indices cannot be linked to one factor, especially if it is external … It would be an oversimplification if the fall in the stock market in India is linked only to the sub-prime mortgage crisis in the US.”

Mr Damodaran played his role as a regulator of the Indian market. He tried to allay fears to keep investors away from a herd instinct of withdrawing from the markets that would weaken the markets even more.

However, analysis will show that complacency is hardly reassuring, given the impact the US crisis can have on the Indian economy.

Could you be more specific?

First, several foreign institutional investors (FIIs) are reeling under the impact of non-performing or bad loans originating in the US sub-prime market. It is likely to slowdown, or even reverse, the flow of foreign direct investments in the Indian economy. This, as you know, will affect the long-term growth prospects of our economy.

Second, several aspects in the Indian housing sector eerily resemble the fundamentals of the US sub-prime mortgage crisis. Property prices here have grown tremendously; borrowing and lending rates have seen gradual increases; banks and other lending institutions have recorded an increase in their non-performing assets.

These point to a cognisable risk of collapse in the Indian credit markets.

What do you think are the lessons for the Indian investor?

It is time the Indian investor took stock of reality. The financial sector in India has a long way to go in developing a sophisticated risk-minimising strategy by adopting complex financial instruments to limit the sources of risk affecting their asset portfolios.

It should adopt better standards to evaluate the credit worthiness of potential borrowers. It should collate and analyse consumer data based on the latest international norms before dishing out loans.

Investors should carefully evaluate the future before taking new loans for asset purchases. As a globally integrated economy, international events will leave its mark on our economy whether we like it or not.

It is important that we remain abreast of what’s happening in the global markets and base our consumption and investment decisions on a judicious extrapolation of the impact of these global events on the Indian economy.

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