Sub-prime mortgages are essentially an American problem but their fallout has been experienced in all world markets right up to Japan. Apart from US, it was Europe that was hit hard.
Defaults were inevitable because home loans were given rather liberally even to borrowers with weak credit histories. The additional risk was, no doubt, covered by higher interest and fees, but not fully. Loans were sanctioned without proper verification of income or a down payment. When the time came for repayment, large defaults became inevitable
The problem would have been confined to the US but for the fact that the sub-prime mortgages were bundled and securitized to be sold in the credit market worldwide. A number of banks purchased these securities and the derivative instruments attracted by the high rate of interest without knowing the actual risk involved. The American problem was globalized.
The mortgage companies were the first to be hit and since they, along with the banks, count for a lot on the stock markets, the Dow Jones and other major stock indexes in Europe, Asia, and South America, came under severe stress. Many markets fell more than 10 per cent but recovered partly later to fall again last Thursday. The Sensex tumbled in tandem.
The defaults in sub-prime mortgages and related securities had dried up liquidity. This would have resulted in a crash in the stock markets but for the intervention by the central banks. The Federal Reserve pumped in $76 billion and brought down the market rate of interest by 20 basis points. The European Central Bank injected 142 billion euros and managed to reduce the euro libor (benchmark lending rate) by 10 basis points. The Bank of Japan similarly enhanced market liquidity by 1,600 billion yen. In just a week, more than $400 billion was injected as cash into the credit market to facilitate payments, restrain interest rates and lift stock markets.
It appears that a bubble has been deflated for the time being. But it has also created new problems. First, with the possible loss of about $150 billion from sub-prime mortgages, lenders have become more restrictive and credit has become more expensive even to good clients. Second, real estate prices have dropped and will further decline with the sub-prime lenders wanting to sell the houses they would be holding as collateral. Both have created uncertainties about the interest rate, the exchange rate and consequently inflation and growth.
Worldwide the exposure to credit default swaps and other derivative instruments is far too large and the markets are still assessing who is exposed and to what extent. Until then there is bound to be nervousness in the stock markets. The exposure of Indian banks to the mortgage crisis is negligible but the impact on the stock market will be just as severe because of sales by foreign institutional investors (FIIs).
The writer is president, RPG Foundation