Business | Opinion
In search of the real trigger of crisis
Subprime collapse is not the main cause of turmoil in the global financial market.
- By Dr Rod Monger, Special to Gulf News
- Published: 23:53 September 22, 2008
The current financial debacle is all out of proportion with conditions in the US housing market. Media references to the subprime or credit crisis are misleading.
In fact, events in the American housing market are only incidental to the real crisis which is that global capital markets are inherently unstable, and are prone to catastrophic failure.
Globalisation has outdated the paradigm for international money management. A new world order is urgently needed to restore stability in global capital markets.
But the United States is not in recession - at least not yet. No one argues that the US housing market has suffered setbacks. But even a cursory examination of the evidence raises the question of how housing losses explain a global meltdown of capital markets?
Why is the global economy suffering so much?
Yet, the US economy has been growing. Unemployment was and still is at acceptable levels. And the US housing market was and still is largely sound.
Moreover, the American government had been actively promoting home ownership even before the Second World War. This was a conscious, broadly-accepted social policy aimed primarily at low- and middle-income people - precisely those who in many cases would qualify for only subprime loans.
This policy was based on evidence which shows that home owners take better care of their neighbourhoods. Better neighbourhoods mean less crime and improved child rearing conditions.
Fannie Mae and Freddie Mac were created partly for this reason followed by legions of programmes to promote home ownership. This policy is a success.
Home ownership rates are about 70 per cent. From an investment perspective, higher interest rates compensated the increased risk of defaults. Indeed, subprime loan portfolios were regarded as lucrative by investors.
The mortgage market also has a number of built-in protections. For example, a person who borrows more than 80 per cent of a home's value must have mortgage insurance which indemnifies the lender.
If a borrower defaults and the lender forecloses, the insurer reimburses the lender for part of any losses. Lenders can and do lose money on foreclosures though losses are typically manageable even in periods of high default.
Consider also that only four weeks before the bailout, CEO Daniel Mudd told investment analysts that Fannie Mae had raised new capital with one issue oversubscribed.
Moreover, capital reserves were above statutory requirements. He also said that the early July period was "the worst Fannie Mae has experienced in the debt and equity markets."
Foreclosures were up dramatically, but Fannie Mae expected to continue generating revenues in the second half of this year "in line with revenues generated in the first half of the year."
Regulator's folly
Moreover, management was taking measures to reduce costs and adjusting prices to weather the storm. Access to capital, Mudd and other Fannie Mae executives noted, posed "challenges ... that are not typical for us."
But Executive Vice President Peter Niculescu told analysts that he thought "that current acquisitions [of loans] are likely to be extraordinarily profitable going forward for Fannie Mae." When asked if Fannie Mae's loan portfolio was likely to grow, he said "I think that modest growth is possible."
The feeling was that the executives were working through the problems. Times were tough, but given the run-up in housing prices, no one was particularly surprised. Yet four weeks later, capital markets are engulfed in flames and the US government is mounting Herculean rescue efforts.
How could the housing situation have deteriorated so precipitously? Even if foreclosures had become significantly greater, which they did, ball park estimates of losses - assuming that the properties become totally worthless - are in the range of $10 billion to $30 billion.
These numbers are manageable. Fannie Mae holds about 45 per cent of all US residential loans totalling $12 trillion. Even at the extreme high end of default estimates this represents less than 1 per cent of the total loan amounts.
Of course, the US housing market is far from perfect. For example, lending is based on current estimates of a home's value. It does not matter that the value increases to bubble proportions as it did early this decade.
Perhaps regulators need to limit the amount of the loan when price increases exceed a predetermined rate. When prices bound upwards, the amount that could be borrowed as a percentage of value would decline. This means that borrowers would have to put more of their own money into the purchase.
But these are side issues. None of this really explains the ensuing catastrophe. Our task is to explore what does account for the crisis.
Dr Rod Monger is a Dubai-based independent writer on global economic and business issues
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