US Subprime Market – What Went Wrong?

Probably, no other issue in the recent times has caught as much global attention as the US subprime crisis, which surfaced in 2007; fittingly it was voted the word of the year by the American Dialect Society. The reasons are obvious. The lending crisis, which hit the US mortgage industry, while first appeared to be confined to only hedge funds (essentially owned by Bear Stearns), has now virtually affected the entire financial services sector in the US. And it’s after-effect is even felt now beyond the US markets – from Europe to even in far-off markets like India and China.

Indeed, the fears of a contagion effect became evident after the British lender, Northern Rock, disclosed in September last year that it sought emergency funding from the British central bank, Bank of England. But it was BNP Paribas, France’s top bank, which set the alarm bells ringing across Europe as it froze 1.6 bn euros ($2.2 bn) worth of funds in August, 2007, citing the problems in the subprime market, which prompted the European Central Bank (ECB) to add emergency liquidity. Commerzbank, Germany’s second-biggest bank in February this year became the latest to be hit by the subprime crisis as it cut $1.1 bn off the value of investments linked to the subprime mortgage crisis amidst warnings that its losses could worsen.

And the losses from subprime-related investments continue to mount. Within a year’s time since the subprime crisis whose first signs became evident when HSBC fired head of its US mortgage lending business as losses reached $10.5 bn in February last year the global economy has lost an estimated $400 bn in subprime losses, according to the finance chiefs of the G7 group. The crisis has impacted the who’s who of the financial institutions – from Citigroup to Merrill Lynch in the US to UBS, BNP Paribas, Swiss Re in Europe, from Mitsui Financial Group and Sumitomo Mitsui in Japan to Industrial and Commercial Bank of China to Bank of China.

Even some of the Indian banks have been hit by the crisis although the extent of losses is small as compared to the US and other international banks hit by the crisis. ICICI Bank became the first Indian bank to report a loss of $264 million in subprime-related investments (mark-to-market losses owing to its exposure to credit derivatives and investments) while it is afraid that some public sector banks with international operation might also have exposure to subprime-related investments.

While the subprime market is facing what is perhaps the worst phase in its history, the usefulness of subprime as a viable model, however, still remains relevant to millions of aspirant homeowners who do not have access to cheaper finance. Subprime lending has indeed helped fulfil the dream of home ownership for many consumers in the US. The US financial crisis, therefore, is a major blow to the dreams of tens of thousands of aspiring home buyers.

But the more serious issue is the impending threat in the form of a recession which is the global economy’s staring at in the aftermath of the crisis and amidst fears of spiraling losses in the financial services sector and growing liquidity crunch. The effect of subprime crisis is felt across a wide spectrum of industries, which include hedge funds, banks, investment banks, real estate and mortgage bond insurance among others. Hence for now, the challenge before the central banks across the globe is to prevent any further damage to the financial services sector and hence the global economy.

N Janardhan Rao, Lead Economist