What’s going wrong in the US banking sector?

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.

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