| Governments
and regulators have stood by and watched as shares have
taken a battering in Asian markets in recent weeks.
In many of these countries, including India, growth
has been and remains creditable and corporate profits
have been soaring. The market downturn everybody agrees
is not the result of poor fundamentals in these countries
but of developments in the US, especially its subprime
housing market where defaults and foreclosures have
been on the rise. Institutions reeling under the knock-on
effects of that crisis are selling out in Asian markets
to find the money to rebalance their capital structures
or meet their commitments. Such behaviour is easily
explained. Institutions overexposed to complex structured
products whose valuation is difficult are saddled with
relatively illiquid assets. If any development leads
to liquidity problems they are forced to sell-off their
most liquid assets such as shares bought in booming
emerging markets. A quick return to stability in those
markets therefore is dependent on developments elsewhere.
Not surprisingly, the decision of the US Fed to intervene
and attempt to resolve the crisis has been received
with much relief. But thus far the Fed's moves have
been limited to marginally improving the flow of credit
to ease the liquidity crunch that is seen as worsening
the ripple effects of the subprime crisis. The Fed has
reduced its discount rate, at which banks can borrow
from the central bank against collateral of various
kinds, including the now dreaded subprime mortgages,
and also extended the period for which such loans were
available from one to 30 days. The discount rate has
been reduced by 50 basis points from 6.25 to 5.75 per
cent—a move that is seen as a precursor to a reduction
in the benchmark rate that would reduce the cost of
credit.
The decision to introduce changes in the discount window
is motivated by the perception that a freeze of credit
flow through the financial system is the way in which
the subprime crisis impacts on other segments of market.
This occurs because of the complex web that liberalized
and globalized finance weaves, starting from rather
simple assets like housing mortgages. Canvassed by brokers
these mortgages are financed by mortgage lenders such
as Countrywide Financial. These lenders then sell some
or all of these mortgages to the banks, especially Wall
Street Banks like Bear Stearns and Lehman Brothers.
Those banks bundle mortgages of different degrees of
default risk to create securities consisting of tranches
that are differentially rated by rating agencies, depending
on the protection from risk they enjoy. These tranches
are bought into by pension funds, insurance companies,
investment funds and hedge funds depending on their
appetite for risks and returns. And some of these entities,
especially highly leveraged institutions like the hedge
funds, finance their investments in these mortgage-backed
securities by borrowing from the banks themselves.
The threads that provide the warp and weft in this complex
weave are credit obligations of various kinds. Institutions
such as mortgage lenders and hedge funds need credit
to keep their businesses going. But credit is difficult
to come by when market sentiment is bleak. And it is
precisely then that the demand for credit rises. Depending
on the contract, lenders can periodically call back
their credit or demand larger margin deposits as the
value of the collateral associated with that credit
is perceived to fall. Investors in funds buying into
mortgage backed securities too want to cut their losses
and demand redemption of their investments. This is
what happens when the market is looking down, worsening
the impact of the crisis. Easier credit, the Fed therefore
believes, will lubricate the market and restor activity.
On the other hand, easy credit is what created the problem
in the first place. When liquidity is easy and interest
rates low, the volume of transactions financed with
credit tend to multiply. But for this to happen the
base assets—in this case housing mortgages—must burgeon
as well. Increasing the volume of mortgages to cater
to the supply-side push created by excess liquidity,
inevitably requires moving into segments of the market
that involving lending to ''subprime'' borrowers or those
with scores for creditworthiness much lower than prime
borrowers..
This was achieved by relaxing income certification requirements
for borrowers. It was also ensured by sweetening loans
with structured interest obligations, starting with
an attractive initial low interest rate and moving on
to much higher rates when the loans are reset. So long
as subprime mortgages remained a small proportion of
the total the risk involved was low. But problems arise
when either designated sub-prime loans increase in share
relative to the total or when some designated as prime
borrowers turn out to be sub-prime.
Both of these have happened in the US in recent months,
assisted by the layered and hierarchical structure of
the financing of mortgages described above. An expected
consequence of that structure is the dispersion of risk
across the financial system. This is partly true. Each
set of players—the mortgage brokers earning a fee, the
mortgage finance companies financing the mortgage but
expecting to be financed in turn by Wall Street banks,
the banks that hope to create securities that can be
sold as investments and the investors who expect their
investment to be financed with credit—bears a small
part of the risk, if any at all. But risk dispersion
does not necessarily make the system safe. Rather, it
reduces the extent of diligence exercised by each player
when choosing to lend or invest. And rating agencies
do not correct for this, since they are paid fat fees
for delivering ratings based on inadequate information
that are often revised when it is too late. The net
result is risk builds up with no response from agents
in an increasingly self-regulated financial system and
little action from regulators who often are not even
aware of the magnitude of the problem.
The structure gives when mortgage defaults begin and
multiply and rising foreclosure reduces the value of
the housing collateral. That collateral also turns illiquid
because of a lack of buyers, since rising default risk
leads to a curtailment of mortgage lending and housing
demand. The first to get hit are the mortgage lenders,
who find that the assets they created are suffering
losses. Even if they do not carry the burden of those
losses in full, they find that financing to carry on
their business from conventional sources dries up. This
is what happened to Countrywide Financial , the largest
mortgage lender in the US, forcing it to opt to use
a $11.5 billion back-stop line of credit it has with
a group of 40 banks.
This liquidity crunch, which Countrywide may temporarily
overcome because of its special circumstances, moves
up the chain. The other set of agents severely affected
are the investors in funds that have bought into mortgage-backed
securities, including funds set up by Wall Street banks
such as Bear Stearns. As mortgage lenders find themselves
saddled with losses and out of business, investors exposed
to mortgage-backed securities begin worrying about the
value of their investments. Rating agencies, keen to
save their reputation, belatedly downgrade these instruments,
encouraging investors to redeem their investments as
soon as they can. Redemption demands increase requiring
the funds to either borrow or sell other assets to meet
redemption claims or, in the extreme case as happened
with bear Stearns to freeze redemptions. The problem
here is that the mortgage-backed securities themselves
can either be sold only at a substantial loss or cannot
be sold at all, since potential buyers have no way of
confirming what their true value is. They become worthless
paper. Borrowing to meet redemption claims would therefore
be the better option, but credit is not easy to come
by since banks are either not willing to lend or are
cash-strapped because funds they have set up or have
lent too are also folding down.
On the surface the Wall Street banks themselves appear
relatively less vulnerable to the default at the base
of the structure, because they had transferred the risk
implicit in their exposure by creating mortgaged-backed
securities and selling them to other investors such
as the hedge funds. But institutions created by the
banks themselves, linked to them in today's more universalized
banking system or leveraged with bank finance often
buy these instruments created to transfer risk. In the
event, as The Economist (August 11th, 2007) recently
put it, ''banks (that) have shown risk out of the front
door by selling loans, only .. let it return through
the back door.'' This it notes is what exactly transpires
in the relationship between the three major prime broking
firms—Goldman Sachs, Morgan Stanley and Bear Sterns—that
offer prime broking services, including loans, to highly
leveraged institutions like hedge funds.
Banks are depository institutions and therefore have
the ability to create credit. But hit by the ripple
effects of crises in other market segments, they too
turn wary and choose to hold onto their balances rather
than lend in times of uncertainty. The net result is
a liquidity crunch in the market that has two effects.
First, many institutions that base their businesses
substantially on borrowed capital such as the mortgage
lenders, the hedge funds and private equity firms are
forced to downsize their operations with attendant effects
on their balance sheets or their investments. Inasmuch
as their operations are crucial to sustain activity
in housing and stock markets (for example), the knock
on effects of the subprime crisis is felt in those markets
as well, resulting in a housing price or stock market
collapse.
Unfortunately this is precisely what has been happening
in most emerging markets including those in Asia, which
have been driven in recent months by foreign investments
in their stock markets, principally by the hedge funds.
When liquidity problems arise, even for reasons unrelated
to these markets themselves or the countries in which
they are located, these investments are quickly unwound
precisely because those markets are still liquid and
a collapse of the kind seen since end-July ensues. It
hardly bears stating that a collapse that is in the
form of a mere ''correction'' can soon turn into a full-fledged
crisis.
Can the Fed through its actions help stabilize these
markets? Not if its moves are merely meant to improve
liquidity. Banks don't lend any more not just because
they are strapped for cash but because they are afraid
of increasing their indirect exposure to the housing
market. If that has to change that market has to revive,
requiring a restructuring of debt. Ensuring that will
require bailing out financial firms by using tax payers'
money as happened with the Savings and Loan crisis.
The Fed alone cannot ensure that. The President and
Congress must join hands with it. And American tax payers
must be willing to comply.
|
