11 Aug 07 How does Subprime Mortgage Crisis affect global Banks and Markets?
Since the Subprime Mortgage Crisis is in the US market, one might wonder how this crisis is affecting banks globally and causing a global securities market meltdown. In the case of mortgage loans, or for that matter any type of loans, banks securitise these loans. Securitisation is the process of pooling in illiquid assets of similar risk weights and maturity period and converting them to highly liquid assets, typically cash. Securitisation is an off balance sheet transaction where the balance sheet of the company is not affected. Now banks offering mortgages will pool these mortgages which have the same maturity period and sell it to a Special Purpose Vehicle (SPV). The SPV will convert these loans (future cash flows) into debt securities and sell these securities to investors. Depending on the credit rating of these securities, the SPV will offer an interest rate which is higher than the interest rate offered by government securities but is lower than the interest rate charged by banks for the mortgages. The cash arising out of the sale of these securities will go to the SPV, which because of the pass through structure, passes this cash back to the bank. The EMI’s paid by borrowers who took the mortgage loan will directly go to the SPV’s escrow account and these funds will be used to pay the interest for the investors who bought the debt securities from the SPV. Now effectively the bank has converted its future cash flows (illiquid asset) into cash (liquid asset). This cash will be used by the bank for further lending (advances).
The debt securities sold by the SPV are publicly traded and are usually subscribed by banks and hedge funds globally. Now because of the high default rate the value of these securities falls drastically and these debt securities become worthless paper. European banks like BNP Paribas had exposure to these securities. It is said that none of the Indian banks have an exposure to the sub prime mortgage collatarised debt instruments. However some banks like ICICI Bank do have a small exposure in these instruments in the US Prime mortgage sector. As of now the crisis is only in the subprime mortgage segment. However there are concerns that it might spread to the prime mortgage segment too and hence globally there has been a market meltdown led by banks who have exposure to the US sub prime mortgage as well as prime mortgage segments. Its my personal opinion that none of the Indian Banks will be affected by this crisis. The fall in the Indian markets is more because of hedge funds who have exposure in the subprime mortgage lending segment pulling out money from Indian markets to manage the liquidity constraint back home in USA. However, the Indian growth story is still intact and the economy is vibrant. Indian markets have overreacted due to global panic. George Soros’ theory of reflexivity offers a good explanation on the market overreactions and is a “must read” for investors. It certainly seems to be the time to prepare a buying list of fundamentally good stocks. I’m accumulating L&T and BHEL as their prices fall. Don’t put all your money at the same time. Keep buying more quantity as and when the stock prices fall further.
11 Aug 07 What is Subprime Mortgage Lending?
Most investors know that the cause of the current market collapse is the Subprime mortgage lending crisis in the US market. However, many investors are not sure what exactly subprime mortgage lending is. Subprime mortgage lending refers to the practice of offering housing mortgage loans to people who do not qualify for the normal housing mortgage loans. When it comes to approving a mortgage loan, banks take into account the repaying capacity of the borrower and his credit history. If a person has a low credit score, it means he is not creditworthy for a normal mortgage loan (also known as prime mortgage). To target such individuals sub prime mortgage lending was introduced. As we know, if the risk is more, banks attach a higher risk premium and hence the interest rate is also higher. Because of the higher interest rates, banks were working on a higher spread and hence the net interest margin of banks active in sub prime mortgage lending was higher. The subprime mortgage lending crisis began with a series of defaults by borrowers who were offered loans at higher interest rates because of their lower repayment capacity. This was a double whammy. First of all, the borrowers who were offered subprime mortgages had a poor credit history and then the higher interest rates charged only increased the burden on these borrowers and made it tougher for them to honour their mortgages, even if they had the intention to do so. This caused a series of defaults which is now commonly known as the subprime mortgage lending crisis.
