The Economic Times daily newspaper is available online now.

    Crisis: Don't blame it on subprime loans

    Synopsis

    It is losses on subprime-related securities and marketisation of loans that created a crisis on such a scale. More from the Columnist I Crisis: India lose some, win some

    There is a pat explanation that���s been put forward to explain the subprime crisis. The US Fed and other central banks flooded the world with liquidity and created an era of low interest rates. Greedy bankers sought to take advantage of low interest rates by selling housing loans to greedy consumers who could not afford these (subprime loans). Once interest rates started rising, defaults on these loans were bound to go up, housing prices fated to fall and institutions exposed to these loans bound to fail.

    In other words, an asset bubble, financial inclusion and human greed combined to create the havoc visited on the financial system today. This is only a half-truth at best. You can have a housing bubble, a boom in subprime loans and lots of greed but it does not follow that there should be a financial crisis.

    Banks��� losses on subprime loans cannot explain the crisis we have today. The US subprime market is estimated to be $1.3 trillion ��� or around 10% of all mortgage loans. How much have banks lost on subprime loans? According to the IMF���s Global Financial Stability Report, October 2008 (GFSR), just $50 billion!

    It���s true that defaults on subprime loans have a snowballing effect as a fall in housing prices begins to impact on the economy at large. But even if we take this effect into account, the losses are not crippling. Losses on all loans, including commercial real estate, consumer loans, corporate loans, etc, have so far amounted to $425 billion with losses being shared by banks and other financial institutions. This is an order of losses that the financial system can withstand.

    However, the financial system has suffered additional losses of $945 billion on investment in securities. Of these, losses on subprime related securities amount to $500 billion. These securities are not entirely subprime-related. Subprime loans are often one underlying component in a package.

    It is losses on subprime-related securities that have complicated matters. An important reason why losses on these have been so large is that the accounting treatment of securities is different from that of loans. Traded securities have to be valued at market prices. If market prices fall below the face value of securities, banks must promptly recognise the associated losses. Loans are not required to be ���marked to market���. Banks make provisions against loans as per regulatory norms.

    Financial institutions invested in securities that were highly rated, meaning the risk of default on the underlying loans was believed to be low. When the default rate on subprime loans turned out to be higher than expected, the institutions panicked and wanted to get rid of subprime related securities. In the market, when everybody wants to exit, prices tend to overshoot their correct levels.

    The market prices of many securities portfolios today are believed to be lower than warranted by the default rates on the underlying loans. For many illiquid securities, market prices are not available. They have to be valued using methods that tend to understate their values.

    The GFSR shows what a world of difference there is between loan exposures and securities exposures. Losses on banks��� housing and real estate loan portfolios amount to only 3.6% of loans outstanding. For the reasons mentioned above, losses on subprime-related securities amount to a staggering 30% of the securities outstanding. Financial institutions are highly leveraged. For an institution that has capital equal to 10% of assets or less, the difference between a 3.4% loss on assets and a 30% loss is the difference between life and death.

    So, explosive growth in subprime loans and the collapse of a housing bubble cannot explain the sheer magnitude of the crisis we are facing today. It was the ���marketisation��� of loans ��� the conversion of loans into tradeable securities ��� that created a crisis on such a scale.

    True, such ���marketisation��� facilitated rapid growth in subprime loans. But rapid housing loan growth has happened elsewhere within the banking system without creating a financial crisis. Banking regulation has responded to the challenge through means such as increased risk weights on housing loans and limits on exposures.

    When loans were ���marketised���, they moved into a netherworld in which regulation was not equal to the task. This is a world that bristles with problems that have been written about so much ��� incorrect credit ratings, large exposures on the part of highly leveraged institutions dependent on wholesale funding, mark-to-market accounting, etc.

    You can have low interest rates, an asset bubble, financial inclusion through subprime housing loans and greedy bankers and consumers. It does not follow that there must be a severe financial crisis. We have one today because traditional loans came to be substituted by financial instruments for which regulation was inadequate.
    The Economic Times

    Stories you might be interested in