Subprime lending was developed in the late 1990s in the United States and became popular in the past five years. Subprime lending simply means lending to people who have questionable capability to repay the loan. Banks, generally, lend to prime clients or those who have a good credit rating. A good credit rating is earned by showing the capacity to pay back loans, no history of late or non-payments, acceptable property for mortgage etc. Those who do not pass the bank checklist are below prime or “Subprime”.
In any transaction, the higher the risk, the higher the rate. Subprime loans carry very high risks for the lender and thus, have very high interest rates.
The Subprime market was an opportunity for financial institutions to generate more profit by developing securities (tradable investment instruments) related to subprime loans. With aggressive global investment banking, these investment instruments with high returns reached financial markets all over the world and were snapped up all kinds of funds. As demand increased, the U.S. financial institutions granted more and more Subprime loans.
Over the past 10 years, the world saw massive inflow of capital to the USA. Savings from Asia and Europe were seeking investment venues to fund their social overhead and sustain positive economic growth. Only the USA had the capacity to absorb these funds. Housing-related investment instruments, subprime lending included, offered a unique opportunity to the entire world.
Meanwhile, the culture of credit spending was pushing the American public to consume more. With credit cards, liberal consumption and now liberal housing loans, America increased its importation thus sending its Dollars to China, Europe and Asia. Awash with US Dollars, these countries were snapping up US Treasury Bills and Bonds and mortgage notes. It was and continues to be a vicious cycle.
On the other hand, the USA housing sector, was going wild. Lenders having cheap funds from the world gave out loans right and left mostly based on perceived increasing value of houses. Mortgage brokers wanting to earn more commissions pushed borrowers to cash in on their “home equities” or to borrow more using their now higher valued homes as collateral. With additional loans, they could fund everything from consumer goods such as toys, plasma TVs (from China and Asia), cars, vacations, second and even third homes. Freddie Mac and Fannie Mae, two Government Supported Enterprises (GSEs) accelerated its massive purchases of mortgage papers from US domestic lenders and issuances of credit guarantees to US as well as global investors.
Investment Bankers and Insurers became more creative to fuel more credit.
More money was made available as investment bankers and insurers became even more creative issuing asset-backed securities and forms of complicated debt instruments. They are not restricted by strict capital requirements as commercial and savings banks. They bundled individual mortgage notes valued based on the increasing housing prices and sold them off to domestic and foreign investors as high yielding instruments. These are the securities referred to as Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs) and other similar structured products.
No real attention was given to the fact that a good number of these mortgages were loans given to borrowers with no real capacity to pay. The commission-driven mortgage brokers aggressively sought out borrowers and arranged housing loans with banks. Banks were eager to lend since they could sell these same mortgages to Freddie Mac and Fannie Mae very quickly. There was just too much money available and too much money to be made in giving out housing loans.
These CDOs and CLOs became even more saleable when Wall Street players included something like an insurance policy in the package (Credit Default Swap or CDS). With the insurance guarantee, rating agencies (like Standard and Pours, and others) gave AAA ratings to these structured products. Thus, even top banks like UBS, and Citicorp invested substantial amounts. Eventually, Citicorp and UBS covered their huge losses of $62Billion and UBS $42Billion with new capital right away. Latest information from the IMF is that Subprime losses of banks have reached over $500Billion.
More and more investment instruments based on the value of other assets or financial instruments called Derivatives, took over the financial markets providing instant margins to traders, brokers, investment bankers and insurers. These Wall Street operations were producing sustained profits out of buy and sell transactions of CDOs and the growing liabilities were not reflected in formal records (kept off-books). All eyes were on the margins and profits as if there were no real risks and as if the increasing price of housing which was the fundamental basis for the asset value would never stop. The fact is, it did.
- What funded Subprime? Too much capital from foreign investors looking for yields higher than what their own countries could offer.
- Where did these funds come from? In the case of China and Asia, their exports to the U.S. mostly made up of consumer goods. In the case of the Middle East, oil proceeds from global energy imports.
- How did Subprime get to grow to such high levels? a) Wall street’s creativity in developing securities without adequate regulation; b) the failure of the established rating agencies to properly assess the true credit risks and c) the unmitigated insurance cover (CDS) on payment defaults sold over-the-counter. Neither the Insurance nor Securities Regulators regulated them.
The US Credit Crisis in Perspective
Here are a few statistics cited from the presentation of Mr. Helmut Schnabel, Chairman of the International Association of Financial Executives Institutes (IAFEI) in its summit last September 5, 2008.
- Total Subprime mortgage loans in U.S. in 2007 was $1.2 Trillion.
- Total private mortgage loans in U.S. today is about $12 Trillion
- Total non-mortgage debt of private households (i.e. credit card, auto loans and other consumer credits) is $2.5 Trillion
- Total U.S. private household debt is thus $14.5 Trillion
- Net worth of private households in U.S. in 2007 (i.e. their total assets less their total debt) amounts to $58 Trillion.
- Private household assets to their total debt ratio is a healthy 5:1
- Actual losses of banks and intermediaries from Subprime loans are in the magnitude of $512 Billion. This represents approximately 3.5% of private debt and less than 1% of private household net worth.
- In the last two weeks, new capital of almost $400 Billion was raised to offset the above losses of the affected financial institutions.
These numbers indicate that it is more fear and panic that is causing the present credit and thus llquidity crisis to further drive financial markets down. More than anything, it is clear that the U.S. consumer and the economy remain viable and nowhere near being in the brink of collapse.
What is the impact of this US credit crisis on our economy
The Philippines is a very small financial market. Our total market capitalization is just about US$133 Billion or US$.13 Trillion. On the other hand, according to IAFEI, “the market capitalization of the worldwide equity and bond markets, plus the worldwide assets of banks, at the end of 2007, amounted to a total volume of over 200 Trillion US $. (Source: IMF, German Central Bank). This puts the value of the Philippine financial markets at a miniscule percentage of .065 compared to that of the world.
From the very beginning, our markets were not really of much attraction to the global financial players. One could say that we simply are too small to spend too much time on. There is another reason why we could not have been a venue for these derivative investments. We do not have financial market infrastructure that would have allowed the kind of loose and free-wheeling over-the-counter trading that caused a lot of unregulated instruments and transactions to take place. In a sense, our “backwardness” kept us out of risk.
But given the extent that our economy is closely related to that of the U.S., significant repercussions could be anticipated in the coming periods. For one, remittances from the U.S., which accounts for a substantial(over 33%) portion of total inward remittances, could temporarily decline. For another, our merchandise exports to the U.S. would more likely also substantially decline. The purchasing power of the American consumers has been severely reduced by this credit crisis. It may take a while to turn that around.
But not all are negative. Outsourcing business from America has a good chance of even increasing, as American business must even now focus more on increasing its competitiveness. And, for reasons still to be studied and understood, oil prices appear to decline as the crisis continues. This can only help us as we face the oncoming (though hopefully) temporary slow down in our economy.
We also have a few aces in our sleeves. Government is accelerating agriculture and infrastructure spending. OFW mobilization continues to be on the rise in more and newer markets for a broader range of skills. Hopefully, these and more innovative developmental spending will not only offset the expected reduction in economic activities from the U.S. but also provide more domestic employment opportunities for our available work force.
The bottom line really is, it’s up to us. We have the power to turn this global crisis to an opportunity for growing our economy our own way.