A housing boom gone awry

The housing finance crisis in the United States holds important lessons for countries like India.

FEW deny that the sub-prime housing loan market in the United States - consisting of loans to borrowers with a poor credit record - is faced with a crisis, reflected in payment defaults and foreclosures. While the crisis is still limited to this segment of the housing finance industry, fears that it would spread to its other segments and overwhelm the financial sector as a whole abound. The problem does not end there. With housing asset values having driven the U.S. economy, which in turn serves as locomotive for the rest of the world, it is feared that this American disease could trigger a global slowdown.

Yet, the problem is little discussed in this country. The assumption is that the problem is quintessentially American. What is missed, however, is that the U.S. experience holds lessons for countries such as India.

A noticeable feature of growth dynamics in contemporary times is that debt-financed investment and consumption spending by households has been an important stimulus to growth. Such spending, in turn, has been stimulated by changes in the financial sector that have increased the volume of credit, eased interest rates and made credit available to individuals and firms that would have earlier been considered inadequately creditworthy.

The last of these changes is of relevance, because it draws into the market for housing and non-essential consumption a set of consumers who would not be present in these markets if their spending were determined by their current income. A credit boom expands the market for certain assets and commodities at a much faster rate than is possible if demand growth were dependent purely on either income growth or on changes in income distribution.

Needless to say, income growth does matter in the medium term inasmuch as indebted households would have to earn the incomes to meet the interest and amortisation payments on their debt. If the requisite increases in income do not materialise, defaults multiply and this unwinds the boom. It would also have collateral effects because it impacts on financial agents left with non-performing debts and assets whose prices are falling because of excess supplies of confiscated assets on sale.

The U.S. is an economy that is now experiencing such a downturn, the full consequences of which are still unclear. The housing market in the U.S. has been crucial to sustaining growth in the U.S. ever since the dotcom bust of 2000. Galloping housing purchases stimulated residential investment and rising housing asset values encouraged a consumption splurge, keeping aggregate investment and consumption growing.

Figures on the annual rate of change in the combined U.S. House Price Index show that the housing market began experiencing a boom in mid-2003, which peaked in mid-2005. Although housing prices have continued to rise since then, the annual rate of inflation has consistently declined.

Some may see this as a much needed correction. But the downturn is giving cause for concern for two reasons. First, as mentioned earlier, growth in the U.S. economy has been sustained by the boom in housing. Rising house values increases the wealth of home-owners and has a wealth effect that encourages debt-financed consumption. This drives demand and growth. The housing boom also pushes up residential investment and construction which, through the demands it generates and the employment it creates, helps accelerate growth.

The second problem lies in the way in which the boom was triggered and kept going. Housing demand grew rapidly because of easy access to credit, with even borrowers with low creditworthiness scores, who would otherwise be considered incapable of servicing debt, being drawn into the credit net. These sub-prime borrowers were offered credit at higher rates of interest, which were sweetened by special treatment and unusual financing arrangements little documentation or mere self-certification of income, no or little down payment, extended repayment periods and structured payment schedules involving low interest rates in the initial phases, which were "adjustable" and moved sharply upwards when they were "reset" to reflect premia on market interest rates. All of these encouraged or even tempted high-risk borrowers to take on loans they could ill afford either because they had not fully understood the repayment burden they were taking on or because they chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming.

The net result has been an increase in defaults and foreclosures. The Mortgage Bankers Association has reportedly estimated the aggregate housing loan default at around 5 per cent of the total in the last quarter of 2006, and defaults on high-risk sub-prime loans at as much as 14.5 per cent. With a rise in so-called "delinquency rates", foreclosed homes are now coming onto the market for sale, threatening a situation of excess supply that could turn decelerating house-price inflation into a deflation or decline in prices. The prospect of such a turn are strong given estimates by firms such as Lehman Brothers that mortgage defaults could total anywhere between $225 billion and $300 billion during 2007 and 2008.

The first casualties in the crisis have been the mortgage lenders, who used borrowed capital to finance mortgage lending. Firms such as New Century Financial, WMC Mortgage and others, which, encouraged by low interest rates and slowing house price inflation in 2006, made huge returns during the boom and expanded lending volumes. This required moving into the sub-prime market to find new borrowers. Estimates vary but, according to one by Inside Mortgage Finance quoted by The New York Times, sub-prime loans touched $600 billion in 2006, or 20 per cent of the total as compared with just 5 per cent in 2001. These mortgages reflected very little own equity of the borrower. According to Bank of America Securities, loans to sub-prime borrowers in 2001 covered on average 48 per cent of the value of the underlying property. This had risen to 82 per cent by 2006. According to Financial Times, more than a third of sub-prime loans in 2006 were for the full value of the property.

Mortgage lenders or brokers were encouraged to do this because they could easily sell their mortgages to banks and the investment banks in Wall Street to finance their activity and make a neat profit. And the investment banks themselves were keen to buy into the business because of the huge profits that could be made by "securitising" these mortgages. Firms such as Lehman Brothers, Bear Stearns, Merrill Lynch and Morgan Stanley bought into mortgages, pooled them, packaged them into securities and sold them for huge fees and commissions. Numbers released by the Bond Market Association indicate that mortgage-backed securities issued in 2003 were at a peak in 2003 when they totalled $3 trillion. Even though total values have declined since then because of the deceleration in home price inflation, they are still close to the $2 trillion mark. Among the investors in these collateralised debt obligations (CDOs) are European pension funds and Asian institutional investors.

With high returns on creating these products and facilitating trade in them, the investment banks were hardly concerned with due diligence about the underlying risk associated with these securities. That risk mattered little to them since they were transferred to the purchasers of those securities. The risks in the final analysis are shared with pension funds and institutional investors, which were buying into these securities, looking for high returns in an environment of low interest rates. They are now experiencing a sharp fall in their asset values and are threatened with losses.

In fact, the process of securitisation involves many layers. To quote the Financial Times, the original mortgages are "sold by specialist mortgage lenders on to new investors, such as Wall Street banks, who then use these to issue bonds which are often then repackaged again as derivatives".

According to that paper, data from the Securities Industry and Financial Markets Association indicate that more than $2 trillion of mortgage-backed bonds were sold last year, of which about a quarter were linked to sub-prime mortgages. In sum, this whole process, which has at the bottom home owners faced with foreclosure, is driven by layers of financial interests looking for quick profits or high returns.

The net result is that the housing market crisis threatens to build into a crisis of sorts in the U.S. financial sector, resulting in a liquidity crunch that can aggravate the slowdown and precipitate a recession. All this has occurred also because of the regulatory forbearance that has characterised the ostensibly "transparent" but actually opaque markets that are typical of modern finance. Investment banks did not reveal the weak credit base on which the mortgage securities business was built; investment analysts routinely issued reports assuaging fears of a meltdown; credit rating agencies did not downgrade dicey bonds soon enough; and market regulators chose to look the other way when the speculative spiral was built.

But now that the crisis has struck, fingers are being pointed at others by every segment of the business. The first fall person has been the ostensibly deceitful home-owner. "Liar-loans", in which the borrower does not truthfully declare incomes, are blamed by the business for its crisis. But it takes little to prevent such activity if lenders actually want to. The Mortgage Asset Research Institute found from an analysis of 100 loans involving self-declared incomes that documents those borrowers had filed with the Internal Revenue Service (IRS) showed that 60 per cent of them had inflated their incomes by more than half. It does not take much to demand an IRS return when making a loan.

The investment banks are, of course, blaming the mortgage lenders. Wall Street banks are filing suits to force mortgage lenders to repurchase loans, which they claim were sold to them on the basis of misleading information. If a Wall Street bank can be tricked, they do not have the right to advise investors where to put their money. And reports have it that those who bought into the bonds and derivatives these banks peddled are planning to move court accusing these Wall Street firms of failures of due diligence.

Finally, the regulators and Congress are sitting up. U.S. Congressmen are threatening to frame a law that restricts the freedoms investment banks and other financial entities have when creating bonds and derivatives by repackaging mortgages to sell them to investors around the world.

But all this is to wake up after the event has transpired. The "efficient" U.S. financial system is clearly not geared to preventing a crisis even if it proves itself capable of finding a solution. A solution that prevents the sub-prime crisis from overwhelming the mortgage business as a whole, by triggering a collapse in house prices, is imperative given the importance of the housing boom in keeping the U.S. economy going. A slowdown in growth may be manageable. But a recession can send ripples across the globe.

All this has lessons for countries such as India. First, they should be cautious about resorting to financial liberalisation that is reshaping their domestic financial structures in the image of that in the U.S.. That structure is prone to crisis, as the dotcom bust and the current crisis illustrate. Secondly, they should refrain from overinvesting in the doubtful securities that proliferate in the U.S. Thirdly, they should opt out of high growth trajectories driven by debt-financed consumption and housing spending, since these inevitably involve bringing risky borrowers into the lending and splurging net.

Finally, they should beware of international financial institutions and their domestic imitators, which are importing unsavoury financial practices into the domestic financial sector. The problem, however, is that they may have already gone too far with the processes of financial restructuring that have increased fragility on all these counts.