The US Sub Prime crisis

(Ref Financial Times dt August 17)

An insightful article by Chris Giles, Gillian Tett and Paul Davies in the Financial Times dt. August 17, has given a detailed account of the US sub prime crisis which has affected markets all over the world.

First the basic facts. The crisis surfaced in February when two specialist lenders to the subprime segment, Novostar and New Century Financial reported losses. New century filed for bankruptcy protection on April 12. In May, another hedge fund Dillon Read Capital Management ran into problems. On June 19, Bear Stearns announced two of its hedge funds had run into trouble. Many other funds reported losses. The common thread running through these troubled entities was exposure to supposedly very safe, highly rated complex debt products, which in turn had exposure to bonds backed by sub prime mortgage debt.

Since then the crisis seems to have hit other sectors. On July 25, financing for two major LBO deals, Alliance Boots and Chrysler ran into problems amidst fears of a credit crunch. Stock markets were hit as a consequence. Money market funds were later hit. A German bank IKB had to be bailed out. Sentinel, a large American investment house recently stopped investors from withdrawing their money. Most recently Countrywide Financial, traditionally considered as one of the most solid mortgage companies lost access to the market for commercial paper and had to draw down an entire $11.5 billion line of credit to boost its cash position. The venerable US government backed Fannie Mae recently announced that it expects higher delinquencies and credit losses this year in view of the credit market turmoil.


What these incidents confirm is that concerns about exposure to risky mortgages have virtually closed the market where mortgage providers resell their loans. At the same time, anxiety has seized the markets where companies raise short term cash. And this is happening not just in the US. In the UK, mortgage providers have come under pressure as wholesale borrowing costs have gone up.

Looking at the turn of events, there is no doubt that the quest for generating more returns has led to more leverage. And financial innovation has resulted in risks being repackaged and sold to entities that are not fully under the control of the regulatory authorities. What seems to be occurring now is deleveraging, i.e., the phenomenon of investors and financial institutions trying to cut their debt in a hurry by selling assets. History tells us that such deleveraging rarely occurs smoothly and usually has some impact on the wider economy. The big question now is whether the US sub prime crisis will spread to the wider US economy and indeed to other parts of the world.

There is no doubt that the contagion is spreading to the banks. One link between the banks and financial markets is the SIV, a vehicle that funds itself in the short term money markets and does not appear on the balance sheets of banks. Many of these vehicles have emergency credit lines with banks. There is a big concern that as normal sources of liquidity dry up, the banks’ balance sheets will come under huge strain as they are forced to bail out these vehicles.

Meanwhile, the “real” economy does look quite healthy. Corporate debt has been falling. The cost of borrowing for strong companies has been flat or falling. Creditworthy households have been enjoying a period of falling long term interest rates. Of course, the sub prime segment has been an exception. But even here, the net economic losses are estimated to be $50 - $100 billion, much smaller compared to the $500 billion savings and loan debate of the late 1980s. The losses will not exceed .05% of the world bond market. A few central bankers have even mentioned that some amount of correction will help in repricing of risk , which is quite desirable.

Meanwhile, the longer the turmoil continues, the more the potential risks to business and consumer sentiment. A serious crisis at a bank or rise in borrowing costs can affect the real economy. If people start saving more, anticipating slower growth or fall in house prices, that too could affect the real economy. This in turn would depend no how households and companies perceive the current events and anticipate the impact.

At the moment, central banks are not showing any panic reaction. They are trying to smooth the process of adjustment to a more deleveraged world and trying to ensure that repricing of risk continues without any major disruption. They are hoping that growth will continue without the need for any major bail out. In case this happens, it would speak volumes for the resilience and maturity of the global financial system.

In a recent interview with the Wall Street Journal, Henry Paulson, the US Treasury secretary and former Goldman Sachs CEO mentioned that the current strength of the global economy is the big difference been 2007 and 1998. The other differences, Paulson pointed out, were the global integration of economies and markets during the past ten years and the large increase in the number and size of hedge funds and other private pools of capital. If what Paulson says is indeed true, there is no doubt that we would have come a long way indeed since the 1998 Long Term Capital Management (LTCM) crisis.