Revival of the U.S. housing market by debt restructuring rather than improved credit flow can help Asian markets recover from the subprime blow.
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 United States, 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 is dependent on developments elsewhere.
Not surprisingly, the decision of the U.S. Federal Reserve to intervene and attempt to resolve the crisis has been received with much relief. But, thus far, the Feds moves have been limited to improving the flow of credit marginally to ease the liquidity crunch that is seen as worsening the ripple effects of the subprime crisis. The Fed has reduced its discount rate the rate at which banks borrow from the central bank against collateral of various kinds, including subprime mortgages and also extended the period for which such loans are 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, which is seen as a precursor to a reduction in the benchmark rate, which 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 the market. This occurs because of the complex web that liberalised and globalised finance weaves, starting from rather simple assets such as 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 banks, especially Wall Street banks such as Bear Stearns and Lehman Brothers. These 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 return. And some of these entities, especially highly leveraged institutions such as hedge funds, finance their investments in these mortgage-backed securities by borrowing from 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 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, 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 restore activity.
On the other hand, easy credit is what created the problem in the first place. When liquidity is easy and interest rates are low, the volume of transactions financed with credit tends to multiply. But for this 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 involve lending to subprime borrowers, or those with scores for creditworthiness much lower than the prime borrowers.
This is achieved by relaxing income certification requirements for borrowers. It is 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 remain a small proportion of the total the risk involved is low. But problems arise when either designated subprime loans increase in share relative to the total or when some designated as prime borrowers turn out to be subprime.
Both of these happened in the U.S. 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. 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 to deliver based on inadequate information, ratings 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 are often not even aware of the magnitude of the problem.
The structure gives way 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 the rising risk of default leads to a curtailment of mortgage lending and housing demand. The first to be 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 from conventional sources to carry on their business dries up. This is what happened to Countrywide Financial, the largest mortgage lender in the U.S., 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 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 worry about the value of their investments. Rating agencies, keen to save their reputation, downgrade these instruments belatedly, encouraging investors to redeem their investments as soon as they can.
Redemption demands increase, requiring the funds to borrow money or sell assets to meet redemption claims or, in the extreme case as happened with Bear Stearns, to freeze redemptions. The problem is that the mortgage-backed securities themselves can be sold only at a substantial loss or not at all, since potential buyers have no way of confirming their true value. They become worthless paper. Borrowing to meet redemption claims would, therefore, be the better option, but credit is not easy to get since banks are not willing to lend or are cash-strapped because the funds they have set up or have lent to are also folding up.
On the surface the Wall Street banks 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 hedge funds. But institutions created by the banks themselves, linked to them in todays more universalised banking system or leveraged with bank finance, often buy these instruments created to transfer risk.
In the event, as The Economist (August 11) 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 exactly what transpired in the relationship between the three major broking firms (Goldman Sachs, Morgan Stanley and Bear Stearns) and the highly leveraged institutions such as hedge funds, which borrowed money from the broking firms.
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 on to their balances rather than lend in times of uncertainty. The net result is a liquidity crunch in the market, which has two effects. First, many institutions that base their businesses substantially on borrowed capital, such as mortgage lenders, hedge funds and private equity firms, 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 are 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 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 stabilise these markets? Not if its moves are meant merely to improve liquidity. Banks do not lend anymore 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 the housing 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.