Who let the dogs out?

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: With each passing day in 2008, it becomes clearer that a world financial crisis is set to grab headlines, at least in the initial months of the year. There are several ways to look at this crisis, like: what could be the severity of such a crisis compared to the one in 2001, or more importantly, will we Indians remain gung-ho about a continuing economic boom? A related issue is the origin of the crisis. To put it another way, the question could be, “What is common between the 2001 and 2008 crises?” For an answer, look at the genesis of the problem.

What is “subprime”? It literally means people with weak credit history. In the US, in the midst of a real-estate boom during 1996-2006, people with poor credit history were lured into buying exotic mortgage loans by brokers. These were actually no-documentation loans that enabled these borrowers to get houses without even having to show evidence of any income or savings. Further, loan incentives, like low initial rates (that could be reset later to higher floating rates), encouraged these subprime borrowers to go for the deal in the hope that refinancing on more favourable terms later would be possible. However, once house prices in the US started to decline in the latter half of 2006, refinancing became difficult. So, defaults and foreclosures gathered momentum.

These initial mortgage defaults immediately impacted the big banks/wholesale lenders that had bought these products from brokers and thus taken on the risk. But many wholesale lenders had sold the risk to Wall Street banks, which in turn packaged these into asset/mortgage-backed securities, whereby the default risk was passed onto third-party investors like commercial banks, hedge funds and pension funds. Here comes the role of rating agencies, as the regulators (in all countries) require third-party investors to purchase only high-quality debts—and the quality is judged purely by rating agencies.

Our story starts here. Worldwide, rating agencies such as Moody’s, S&P and Fitch play a significant role in debt markets, as these entities rate/grade debt instruments either as investment or non-investment grades. Within investment grades, paper with the highest rating is labelled “AAA”, implying that it has minimal risk level. Papers rated in non-investment grades are not considered investment options.