Subprime mindset
Indian Express, 18 August 2007
Thursday saw another expression of global market nervousness, due to changes in the US ?sub-prime market?. Listening to stories about sub-prime securitised house loans in America is a bit strange in the Indian context ? it?s like a remote village trying to make sense of an event in the national capital.
India is still a financial market amateur. Over the last few years we have barely managed to gain familiarity with EMIs and home loans. And home loans in India are still not pervasive. Most households are excluded from the home loan market. Those with a high probability of default are simply not given loans. Exclusion from the home loan market is the norm for the bulk of the poor. Even when loans are given, they are given by banks. The risk is on the balance sheet of banks and ultimately of the public that deposits its money in banks. If borrowers default, it is the bank that gets hit.
Home loans in developed financial markets are more complex. Thousands of home loans get bundled together through a process called securitisation. These securitised bundles are then cut up into assets with different grades of risk. The transformation of risk takes place twice. First, pooling thousands of loans into a diversified portfolio yields a reduction in risk through diversification, in a manner similar to that found in insurance. Second, the pooled portfolio is then cut up into high-risk and low-risk grades, which are separately traded. When loans are repaid, the first people to get paid are those, like pension funds, who bought the low-risk assets and whose returns are also lower. Those who could afford to take on more risk, like hedge funds which cater to rich clients in the hope of getting higher returns buy the high risk assets. In the event of defaults, they are the ones who get hit. The clever financial innovation of splitting the risk allows the pensioner who does not like to take risks to get a small monthly cheque regularly, while the rich client who chooses high-risk and high-return assets makes money when the market does well, and loses when it goes down. The best thing about this innovation is perhaps that the losers are those who can afford to lose, who are prepared to lose and therefore bought the high-risk assets. So, when a worker loses his job and defaults on his housing loan, the pensioner does not suffer, the rich hedge fund client does.
The US sub-prime market was a set of innovations through which home loans were given to individuals normally considered unsafe credit bets. Defaults rates by these individuals are as high as 30 per cent. But when the ?sub-prime crisis? is judged, it should be remembered that 70 per cent of the loans were and are actually repaid successfully. These people were able to get a home loan because of financial innovation. Financial innovation led to financial inclusion.
In India when we talk about financial inclusion we might think of microfinance and how to give loans to banana sellers. When we think of housing for the poor we draw up schemes like Indira Awas Yojana that can barely meet the housing requirements of a fraction of the poor. We do not talk about tapping into modern finance and financial innovation to provide housing to the poor.
Why? One of the main reasons is our fear of modern finance and the fear of the boom and bust that it brings. It is true that the processes of a market economy are not smooth and stable. They deliver immense wealth and technological progress through a system of creative destruction. Risks are taken. By definition, risk involves a fair chance of failure. Many business enterprises fail. There are times when an entire industry makes a huge investment in a certain business plan, and a whole group of firms fail.
Such failures are an integral part of the processes of the market economy. As an example, in the late 1990s there was a great IT boom. That involved large investments in mobile telephony, computer networking, etc, undertaken by firms worldwide with resources made available through financial globalisation. Then came the IT bust, when a lot of these firms went bankrupt. In the end, if we have ubiquitous cheap mobile phones and Internet connectivity today, accompanied by a never-ending array of clever devices, then the credit for this goes to the IT boom.
When governments get focused on the bust, and try to prevent the bust, they also prevent the boom, thus blocking progress. The effort at achieving stability means losing out on the dynamism of capitalism.
The state financial regulation seen worldwide is vastly ahead of India. Over the years, many problems have arisen and led to improvements in regulation. The sub-prime crisis will lead to new thinking and regulation on transparency. Along with innovations in financial instruments will come learning in regulation.
Conservatives in government will point to the sub-prime crisis and take pride in having blocked India?s progress, in having prevented sophistication of financial markets. As Percy Mistry wrote recently, the
Indian response to the Asian Crisis of 1997 was reminiscent of a slow-moving bicycle (India) looking down on a BMW (South Korea) that had punctured a tyre. The right response in India is to be embarrassed that we do not even know what a sub-prime loan is, to notice how backward
Indian finance is, and to have the courage to take on modern finance and the challenges it brings.
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