Inside the financial tsunami: what brought it on?

October 3rd, 2008 - 11:51 am ICT by IANS  

New Delhi, Oct 3 (IANS) The financial tsunami now inundating global economies and markets was brought on by imprudent easing of US lending norms and extreme over-leveraging by giant US investment banks, analysts say.The dotcom bubble burst in 2000 and the collapse of the World Trade Centre, a mighty symbol of US economic and financial prowess in 2001, made Alan Greenspan, the then chief of the US banking regulator, the Federal Reserve, believe that a US recession was a certainty and it had to be staved off.

His solution: Increase liquidity in the system. The mechanism: Ease lending norms, especially for the real estate sector.

The result was aggressive lending by banks to home loan borrowers, defying time-tested, conservative and prudent norms of ensuring that the loan amount did not exceed the value of the asset being purchased.

Thus was born the concept of home equity, when if you asked for a $1 million loan to buy a house, US banks lent $1.2 million in the belief that real estate prices will only go up and never come down.

In contrast, in India or in all other countries in the world, banks lend only about 80-85 percent of the value of the asset, and the borrower has to pay the balance.

Greenspan’s thinking was that lenders would use the extra funds to spend on other items of consumption and recession would be beaten.

Not only that, in their bid to capture market share, banks lent even to people with doubtful creditworthiness.

In the US there are three classes of borrowers - prime rate borrowers who have the highest creditworthiness, followed by what are called Alt A Mortgage borrowers and finally subprime borrowers who have the least creditworthiness.

As banks can charge a higher interest rate from borrowers with less than best creditworthiness, aggressive marketing saw a more than prudent share of loans going to the least creditworthy borrowers.

“Whether we like it or not, the laws of gravity work in financial markets as well and what goes up ultimately comes down,” Jagannadham Thunuguntla, head of the capital markets arm of India’s fourth largest share brokerage firm, the Delhi-based SMC Group, told IANS.

Despite a bull run in the US real estate market due to the big rush in home purchases during 2002-06, the party had to end some time and prices began to come down.

Real estate prices have fallen 16 percent till July 2008 since the corresponding month last year and had fallen by a similar amount the previous year.

Suddenly, from early this year, banks found their so-called home equity had completely vanished and their loans were not protected by the value of the assets bought with the loans.

Alongside, there was another development.

In normal manufacturing and other businesses, the debt to equity ratio is usually in the range of 1.33-2 to 1.

This means, out of the total capital invested by a business, if $1 is the promoter’s equity, borrowed funds invested in the business is $1.33 to $2.

But in the banking industry, the debt-equity ratio is always much higher because the deposits of banks are considered as debts of the bank.

Commercial banks, however, despite their high loan-deposit ratio (conceptually similar to debt-equity ratio) are highly regulated as they take deposits from the public and have to follow strict lending, provisioning and capital norms.

Investment banks, such as Goldman Sachs, for example, are, however, very lightly regulated and do not have to follow these prudential lending and capital norms.

Just before Goldman Sachs got into trouble two weeks ago, it had debts of about $1.08 trillion against its own equity capital of only $40 billion. This means it had a debt to equity ratio of 24.7:1.

To simplify the explanation, let us say its debt-equity ratio was 24:1. That means of every $25 it was investing or lending, $1 was its own money and balance $24 was borrowed money.

In this situation, even if it incurs a loss of four percent on its loans or investments, the bank runs up a loss of $1, which is four percent of $25 originally invested.

This in turn means the entire equity capital of the bank is wiped out and it has to file for bankruptcy because losses have to be borne by the owner of equity capital. Borrowed funds have to be returned to borrowers.

It is very usual for any bank to make a mistake in lending or investment decisions to the extent of four percent.

In the real estate boom of 2002-06, banks had lent an imprudent share to Alt A mortgages and subprime borrowers. Running up a four percent or more non-performing assets was just waiting to happen.

When it happened, Goldman Sachs as also all the other investment banks which had equally high debt to equity leveraging found their capital eroding too fast for their comfort.

Lehman went down first, followed by the others and Goldman and Merrill Lynch are surviving by infusing more capital through sale of some of their assets.

For example, after the crisis broke, US investor and one of world’s richest men Warren Buffet and others stepped in and pumped in about $7.5 billion equity into Goldman Sachs and brought down its leveraging to 20.8:1.

In good times, however, even a four percent return on their capital, that means a return of $1 on the $25 invested would translate into a 100 percent return on these banks’ own equity capital of $1, Thunuguntla explained.

The problem with the European banks was they too had big exposures in the US market during the real estate bull phase and they too did not follow prudent loan to deposit ratios.

A prudent loan-deposit norm for commercial banks is around 80 percent. That means they lend 80 percent of their deposits and keep the balance 20 percent to service depositors.

Northern Rock, the first British or European bank to be hit by the subprime crisis and nationalised in 2007 had a loan-deposit ratio of 215 percent.

Most of the other banks hit also have excessive loan-deposit ratios of around 160 percent so that when faced with troubled assets they are no more able to service depositors.

“Indian banks are safe and sound mainly because of our extremely prudent banking regulations,” Thunuguntla said.

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