Bhuvaneshawari Das Iyer
The current subprime crisis is more a crisis of sub prime lending, and not bank over-lending
The ongoing sub-prime crisis has already registered a lasting impact on the world’s leading financial institutions. Stock traders are full of stories about how the sub-prime crisis took a toll on them, as well as hundreds of other big and small investors.
The current subprime crisis is more a crisis of sub prime lending, and not bank over-lending. Banks do not have enough money to lend. We have to turn our attention to subprime lending.
Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk.
With potential annual adjustments of 2% or more per year, these loans can end up charging much more. A Rs. 500,000 loan at a 4% interest rate for 30 years equates to a payment of about Rs. 400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of Rs. 4,470. A 6-percentage-point increase in the rate causes more than an 85% increase in the payment.
From a servicing standpoint, these loans have higher collection defaults and experience higher repossessions and charge offs.
The subprime lending was 9% in 1996 but in 2004 it became 21%. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others.
Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy.
The crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities, snapped up by banks, traders and hedge funds on the US, European and Asian markets. With the onset of the crisis, those who bought into the market suddenly found their investments valueless. Ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly faced difficulties. Some even folded up due to the banks’ unwillingness to budge on credit lines.
It is also necessary to analyse the sub-prime crisis from India’s perspective and draw lessons.
The present case pertained to mortgages. After 2000, the US markets witnessed an environment of benign interest rates, which encouraged cheap borrowing and fuelled housing prices. Too many so-called innovative loan products began floating in the Indian markets, promising convenient re-payment options at the start of the mortgage. Borrowers rushed to buy homes far more expensive than their financial situation would have permitted.
The Indian banking system has remained fairly insulated from any direct impact of the US sub-prime crisis, only because of lack of significant exposure to sub-prime loans in the US. But many foreign institutional investors (FIIs) have sold off their investments into Indian companies to cover their huge losses, with the attendant impact on equity markets. Further shocks in the global sub-prime sector are likely to cause havoc in the Indian equity markets.
A sub-prime crisis type scenario in India may be unlikely, given that the mortgage market in India is nowhere close to the levels of developed countries, primarily the US or the UK. Mortgages are only a small percentage of the GDP. India’s regulatory bodies adopt a fairly rigid and balanced approach to ensure that the money supply is kept within manageable limits. Housing sector-related are mainly due to supply and demand. Regulatory authorities have to ensure that banks eschew imprudent and predatory lending practices. Pumping money into markets as a temporary measure will increase inflationÃ‚Â already a hot issue in IndiaÃ‚Â which will result in increase in subprime lending. Reducing bank reserves to small extent is better, but this could end up destabilizing the entire financial system.
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