Even a year and half ago, the US
economy was on the up with GDP growth rocking at 3.5
per cent. True, the current account deficit was a
staggering $800 billion; and there were 17
consecutive interest rate hikes by the Federal
Reserve. Yet, banks continued loaning to virtually
anyone who wore clothes. Consequently, even in
January 2006, there were 2.27 million housing starts
in the USA — its highest in many years.
So long as the economy grew, so too did the value of
houses. Since home equity was rising merrily, banks
became less fussy about whom they lent against home
mortgages. Borrowers with dodgy credit ratings and
poor income streams were disbursed mortgage-backed
home loans at higher interest rates — on the ground
that the rising value of property more than offset
the credit risk.
Bankers don’t hold mortgages till maturity. They
create mortgage backed securities or collateralised
debt obligations (CDOs) which are sold to other
banks and financial institutions. The sellers get
cash; the buyers get a stream of interest payments
defined by the terms of the security and their
seniority in the debt structure. The housing boom in
the US since January 2003 created many trillions of
dollars of CDOs that were bought as assets by banks
and financial institutions throughout the developed
What goes up must come down. Soon enough, the Fed
rate hikes started to bite, and the first casualty
was housing. By April 2006, the rate of growth of
new homes turned negative. It has remained so for
every month since — with negative growth rates now
in large double-digits. The fall in demand for
housing resulted in an even more precipitous fall in
home values. This triggered two things: first, the
beginnings of home loan defaults, especially in the
sub-prime category; and second, the fall in value of
sub-prime mortgage backed securities and CDOs.
Marked to market, banks holding these instruments
had to reckon with big hits on their asset book.
Then came the first sign of panic. It happened this
month in the United Kingdom with a home-loan bank
called Northern Rock, which is chaired by Matt
Ridley, one of Britain’s best science writer and the
author of the best-seller called Genome. Northern
Rock’s large stock of CDOs had started to default;
and when marked to market, the bank just didn’t have
adequate capital to cover its deposits. Amidst
anxious negotiations between Northern Rock, the
Financial Services Authority, the Treasury and the
Bank of England, depositors got wind of the problem
and began to queue up to withdraw their money.
Screaming headlines and pictures of thousands of
panicky depositors snaking round the block was too
much for Prime Minister Gordon Brown and his
Chancellor of Exchequer, Alistair Darling, to
stomach. They immediately decided to protect all
deposits in the UK — not just those of Northern
Rock. While in theory, this has converted private
liabilities to contingent public debt, it poured oil
on troubled waters. The depositors went home.
Is this the end of the sub-prime crisis? I fear not.
There are probably a dozen to twenty state-level
banks in the US that are overstocked with CDOs
which, if properly marked to market, will lead to
major hits in their already stretched balance sheet.
Moreover, there is enough evidence to suggest that a
few large enough banks in Europe are also overloaded
with CDOs and haven’t yet marked their rapidly
declining assets to market. Unless the US housing
market suddenly picks up and heads resolutely north
— and nobody sees that happening in the near future
— I believe the world will some more bank shakeouts.
And they could be more serious than Northern Rock.
Thankfully, India is immune to this potential
crisis. Except in one way. If there were to be a
simultaneous implosion involving three or four large
banks, you can be sure of a global liquidity
squeeze. That can affect our markets, portfolio
inflows and the ability to finance global
acquisitions. Otherwise, we are in safe harbour. For
once, thank the Lord for our tougher lending
Published: Business World, September 2007