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.
Rating agencies in India (Icra, Crisil, Fitch and Care) are mostly associates of global rating agencies, and do play an active role in debt as well as equity markets (grading IPOs, for example). But more importantly, ratings operate in an oligopolistic market, with too many issuers chasing too few rating agencies. Consequently, some of the ratings themselves are debatable.
In the context of the subprime crisis, international rating agencies have been roundly criticised for their indirect role in accentuating it, with some of the reports harping on an apparent conflict of interest: ?Mortgage securities involved are largely based on mortgages sold by lenders to investment banks.?The private rating organisations are paid large fees by the issuers of these securities to issue their ratings.?
Without even going into the conflict, rating agencies have much to answer for. When a bank creates mortgage-backed securities, it discusses with these agencies the quality of the debt contents therein, including subprime debt, before slicing up the security into several pieces in order to get the desired rating for each portion. Even if we assume that this did not happen, the agencies failed with their due diligence. Remember the age-old proverb, ?One bad apple spoils the barrel?? Even if there was a single subprime borrower, the entire security should have been rated as non-investment grade.
There is another aspect to this. Since these securities are backed by assets, in common parlance, rating agencies consistently rated these mortgaged-back securities as ?investment grade?, meaning they?were seen as carrying low risk. With the onset of the subprime crisis, some of the papers earlier rated as AAA have now being downgraded. Interestingly, the downgrading of AAA-rated papers reminds me of a typical problem in India. My analysis shows that a majority of the rated securities that defaulted over the studied period in the Indian market were initially rated by Indian rating agencies as AAA. Rating agencies will say they had downgraded these papers before their default. However, the fact is that these agencies failed to anticipate it in the first place.
To conclude, here is the answer to the question in the first paragraph: the common theme of the 2001 and 2008 crises is that both were man-made. What baffles me is that even with the most sophisticated risk systems, these developed countries were unable to anticipate future risks. This emphasises that ?unless the government acts, credit ratings agencies will stand on the sidelines of the coming crisis, doing nothing until it?s already happened?. To end on a positive note, I believe that the Indian economy will continue its growth story.
The author is a director with a leading MNC. These are his personal views