We read it in the papers, see it in the news, hear about it everyday - ABC bank has gone bust; they are waiting for XYZ bank to be taken over etc.
What is happening with these companies and how did it all start?
Let us look at the basics of how this started.
For banks (lenders): About four years ago, banks came up with a new financial product and found that they could package the loans or other assets on their balance sheet and sell them in return for immediate liquidity. This would give them liquid funds which could be lent further to increase business.
Hence, with more funds at their disposal, they started lending more money, even to people who would not have been eligible borrowers otherwise. Loans were made to to people who did not have perfect or good credit history or a steady income stream; these were called sub-prime loans. Slowly various others such products related to loans were created and gained popularity; these products had higher risk but also higher returns for banks.
Meanwhile property prices were soaring. A look at the statistics shows property prices in the US (where this problem is the biggest) rose 53% in the five years ended December 2007. People, on the other hand, had started buying more homes with mortgage loans, now easily available from banks. The rise in property prices was not entirely due to healthy demand and supply factors, but more due to this easily available money. This fueled the construction industry, property markets, etc.
For investing companies (which included banks): The loans that were packaged (securitized) and sold by banks were held as collateral against which securities were issued to investors (which are generally financial companies). These securities, called asset backed securities (ABS), could be traded in the secondary market. The repayments on the loans that were held as the collateral would provide for returns and principal repayment to these investors.
Start of the crisis: As interest rates kept increasing, the monthly installments payable by mortgage loan borrowers started rising. Slowly, borrowers started defaulting on their loan repayments. This raised the level of non-performing assets or problem loans for banks.
These defaults also led to disturbance in the cash flow to ABS investors. The risks related to this type of securities increased and their market value consequently decreased. The investors started incurring losses which decreased the viability of these securities. Soon the market for these securities slackened and losses (both realized and marked to market) started eating into investors’ profits and affected capital negatively.
Besides, banks could no longer easily securitize their assets. This led to lower availability of funds and hence low business volumes. Since loan disbursement was now selective, investment in property was lower and property prices started declining due to lack of demand. This in turn decreased the value of collateral for mortgage loans given by banks and increased the risk attached.
Securitization of loans led to more funds with banks, higher and riskier lending, defaults on repayments, losses for banks and ABS investors which made a large hit on profits and capital. All these things were hence interlinked and one after the other led to weakening of the entire system.
Thanks to the more-than-adequate regulation by the RBI this has not happened in India. However, let’s see how much this affects Indian Banks and the economy indirectly.
October 1st, 2008 at 7:21 pm
Hello Durva,
I would like to compliment your write-up. It is a nice way to make a layman person understand about the root reason for the current financial crisis.Hope, India does not have to undergo such a crisis situation anytime.
Thanks
regards,
Varsha Dhuri
October 1st, 2008 at 8:01 pm
Good article….
Do you think is there any other collateral that can pop up in future and cause similar issue..
October 1st, 2008 at 8:04 pm
Hello Durva,
I got another story that explains this credit meltdown in the US.
http://www.nytimes.com/2008/10/01/business/economy/01leonhardt.html?_r=1&oref=slogin
I thought this one was very well written, easy to understand.
I just wanted to ask one question: who made those ABSs? As far as I could tell from the blanket coverage of the crisis in the US is that investment banks purchased the mortgages from the banks, lumped them into these ABSs and sold them off to everyone who was willing to buy. I have seen stories of retirement funds and school funds in Norway who have bought these securities. And from what I hear, banks and financial institutions here in India are also exposed to these products. I read somewhere that one of our major banks expect to recover 70% of their exposure in this mess.
I am hoping that this discussion goes forward a lot more.
October 1st, 2008 at 8:53 pm
Hello Anup,
The initial ABS was invented in the form of Mortgage backed securities (MBS) in the 1970’s. It was widely used primarily in the US. Figures till 2001 clearly show this, as the MBS as a percentage of mortgages outstanding was around 60% in the US while that in Canada and Australia was around 20%. So we see that even in 2001 the US was deeply into the practice of securitisation and now we are 7 years ahead.
You are absolutely right in your understanding of the way ABS are used. Yes a large Indian bank does have exposure to these securities, but these securities as a percentage of the assets is not a very large number.
October 1st, 2008 at 8:55 pm
Thanks for your appreciation Satish.
Even if there are any other assets which could face similar issues, they would not be so inter-related with the financial system and the quantum of usage would not be so huge.
October 1st, 2008 at 8:55 pm
Hi,
Thanks for summarizing it in simple terms. This is exactly what has happened.
This is one of the classic case of spiral fall. One event leading to another.
Want to add a point here regarding the 700 Bln dollar bail out by the US govt. I have my doubts, whether this would be sufficient for buying out all the bad assets. If we take an average house price as 100,000$. The Govt. can only bailout 7mln houses I don’t think that would be sufficient.
A question - what do you think, about the next level of possible disappointment our world can see?
October 13th, 2008 at 2:02 pm
I liked your article..its a very difficult concept to understand for a layman and you made it easy to understand, the repercussions of sub prime is faced by some big companies, I hope we learn lesson from their mistakes and inability to see the future, as we cannot afford such set backs under a growing economy.
October 13th, 2008 at 3:36 pm
Hi Durva,
You have explained the cause behind fall of US banking sector very well. But you tried to blame ABS for the whole crises, i would like to differ here because ABS is an instrument which can be used very effectively to increase the liquidity of the banks.
It can be used for their asset liability management purpose, ABS is a very good financial instrument, but was used badly by the banks.
October 13th, 2008 at 3:53 pm
Hi Durva,
You talked about ABS, Banks and Investors but you forget to mention the contribution of credit rating agencies (who rated these ABS) in the crises.
Over all a nice article.
October 13th, 2008 at 8:39 pm
Bidya- If we look at it the way you have put forward, in case of a loan for $100,000 home, the entire money will not be lost, i.e. some of it can be recovered through some monthly payments already paid and also sale due to Foreclosure. Hence, it will be useful for a lot more homes (holding on to your line of thought).
Vinita- Thanks for your comments. We are really seeing the worst and any wosre would not want to be thought of.
Savita- If you read the article carefully, it says that a mix of various factors has led to this crisis. ABS is, as you truely said, an amazing product for ALM, but has been misused to a great extent. Besides, the opaque nature of information on these products and agressive growth (which leads to poor quality controls) by banks have been instrumental in getting to the current situation.
Manisha- Good to know that you have the role of ratings agencies in mind which has given good ratings to instruments without proper information in hand. There are many points to be discussed related to the crisis, which may not figure here in order to maintian simplicity for the layman and not divert from the cruz of the matter. I would be happy if you could post a separate piece talking about the subject of rating agencies role.
October 14th, 2008 at 12:44 pm
The article is directed towards the subprime crisis, however author has not spoken much about that or enumerated enough scenariors about that subject..it could still have been better…overall good attempt.
October 14th, 2008 at 1:05 pm
I have read your article very carefully Durva, in your article you talked about only one factor (ABS) all others were outcome of that according to your article.
Whereas Sub-prime lending in itself is the biggest factor, even if banks have huge funds for their disposal they cannot justify sub prime lending.
And I don’t think ABS is much complicated than any other derivative instrument, when you and I understand ABS, people sitting in Lehman & Goldman obviously does.
Problem lies in the underline asset not in the product.
October 19th, 2008 at 4:07 pm
Jonnie Walker- Thx for your suggestions.
Savita- Subprime lending is a lapse of risk management by the banks. However, the situation was aggravated by the product, ABS, as many other institutions also ultimately got involved in it. While subprime in itself would have a caused a crisis (which would have been concentrated only in the US, maybe UK and few European countries), it would definitely not be as big, rampant and widespread without this product. You can see banks which were not active in these markets are quite on the safer side, like Banco Santander, BNP Paribas etc..while others, which may not have been into subprime lending but were large investors in these products have suffered huge write downs. So the problems lies first in the underlying and was aggravated to this mammoth level by the product.