Harry Potter vs Lord Voldemortgage

Written by Deepali Pant Joshi | Updated: Apr 29 2008, 01:30am hrs
The evil that men do lives after them; the good is oft interrd with their bones. So it was with Caesar. And so with Alan Greenspan. Today, Greenspan bashing has become the order of the day, and the woes of the US economy are being laid at the door of the Feds loose monetary policy earlier this decade. The policy undoubtedly stimulated growth, but also encouraged subprime lending. The US housing boom was fuelled by home finance firms, which guaranteed the repayment of the dues. A competitive financial sector narrowed the spreads through several innovations of risk dispersal. Wall Street banks and securities firms, powered by whizkids, repackaged mortgages into securities through credit derivatives and collateralised debt obligations. They turned structured finance from a staid capital market wallflower into a swashbuckling life-of-the party growth engine. Mortgages were freely traded and came to have greater value than the underlying asset. It was boom time, big time. Floating rate mortgages at attractive teaser rates were offered to high-risk borrowers who didnt understand how unsustainable a loose policy is and did not expect rates to return to normalcy. Loan packagers were incentivised to expand operations, given rising demand for high-coupon securities. All this vastly enhanced the market for lemons (remember the asymmetry argument) in the secondary market for loans. This gave loan originators, mainly banks, greater balancesheet flexibility.

Overextended borrowers were soon unable or disinclined to pay their instalments. Retail payment defaults first affected mortgage lenders, who had passed on the risks to third party investors via derivatives. As payment streams dried up, the value of underlying assets went into freefall, and financial markets underwent a seizure.

This was the anatomy of the worst financial crisis since World War II. On August 2, 2007, IKB Deutsche Bank AG was the first to break the bad news, followed by BNP Paribas on August 9, the second domino to fall. Within weeks, defaults and foreclosures threatened to spiral out of control. Post-crisis, a number of other aspects have gained currency. The crisis occurred, they say, as market players were often unregulated and undercapitalized mortgage originators who operated with very little capital and used short-term financing to fund subprime mortgages that they did not expect to hold for very long. Once the US housing market started crashing in 2007, whoever left holding the can was in trouble. As asset-backed securities were downgraded, issuers of such paper found it extremely difficult to roll over maturing asset backed paper into new longer term paper. When these could not be sold to finance whizkids to package into readily marketable securities, uncertainty took hold. As soon as the markets solvency troubles emerged, players became illiquid, and trading ceased. So diffused had risks become that market participants were unable to identify their nature and location, so everything underwent reappraisal. Naturally, lending rates shot up.

In this scenario, it did not take very long for confused and scared investors to grow panicky and try to flee. This was styled as the great credit crunch of December 2007. Interbank markets became very disorderly as default risks increased, and central banks had to exercise their role as lenders of last resort.

Several issues are now left to be agonised over. In retrospect, the use of innovative credit instruments led to dispersion of risks, but also placed too many layers between the points of possible default and where this risk was borne. Special investment vehicles and hedge funds had scarcely any idea of their locus of vulnerabilities in the real world of houses and repayments. An apt analogy is the Horcruxes from the Harry Potter series. These are disaggregated pieces of the soul of Lord Voldemort. Like mortgage risks, they are dispersed for safekeeping in unknown places. Like in what was arguably the most popular book of 2007, all the Horcruxes must be expunged, before the dark lord Voldemortgage has a chance to wreak further havoc.

The author is chief general manager, Bankers Training College, Mumbai. Email: deepalipantjoshi@rbi.org.in These are her personal views