Thursday, October 30, 2008

Don't blame it on sub-prime loans

That's the title of my column in ET today.

The present crisis has been called a 'sub-prime crisis'. This does suggest that sub-prime loans- loans to not very credit borrowers or financial inclusion- underlies the present crisis. Once you take this view, there is a whole cast of villians available- the US Fed which flooded the world with liquidity; greedy borrowers; greedy bankers; political pressure for financial inclusion.

This, I argue in my column, is rather simplistic. There have been housing bubbles earlier, banks have extended themselves in making housing loans but we have not had a global financial crisis. To complete the chain of causality from a housing bubble through sub-prime loans to a financial crisis, you need to bring in a vital link: the 'marketisation' of loans, that is, conversion of loans into traded securities.

This 'marketisation' was made possible by incorrect credit rating. The securities passed into the hands of non-regulated or lightly regulated entities such as investment banks and hedge funds. These institutions face mark-to-market accounting on their securities portfolios whereas bank loans are not marked to market. This sort of accounting tends to exaggerate losses especially where illiquid portfolios are concerned.

If the financial system had been exposed only to sub-prime loans, we would not have had such a big problem. It is their exposure to sub-prime loans through sub-prime related securities that has created havoc. So, the problem is not financial inclusion, it is poor regulation.

1 comment:

Krishnan said...

I fail to see how "deregulation" had anything to do with it (or not enough regulation) - Since Sarbanes Oxley and Elliot Spitzer wreaking havoc on Wall Street, a lot of financial business fled Wall Street. The Journal in an OpEd piece by Freeman reminds us that regulatory spending has actually gone up (OK, I can see the counter argument that it was not enough or was in the wrong areas or whatever).

The single most important factor (if there is such a thing) is the wilful intent of Congress (Barney Frank and Christoper Dodd) to ignore the dangers posed by Fannie and Freddie and the deliberate attempts at encouraging (forcing) lenders to lend to less than worthy customers. 750 billion is nothing compared to the more than 5 trillion assumed when the Feds took over Fannie and Freddie.

This crisis, like other crises, will look different depending on the political spectrum we fall under. The pendulum is swinging and it seems to me that we are in for some really deep, dark, dangerous territory where the free market will take the blame for all of our ills and the world economy will stagger.