Lessons from credit crisis

When the US sneezes, the world catches cold. At least that used to be the old saw. But these days, the US economy is feeling poorly, with the so-called sub-prime credit crunch and weakening dollar. But the local UAE economy doesn't even have the sniffles.

Of course, the US is still a major factor globally with an estimated 30 per cent of the total gross domestic product, 20 per cent measured by purchasing power parity (an adjustment economists make which takes into consideration inflation and foreign currency exchange rates).

But that share continues to shrink (from about half of the world production just after Second World War) due in part to fast growth in countries like Brazil, Russia, India and China, which together now exceed the US share.

Still the US cannot be ignored, especially in the UAE which continues to tie its currency exchange rate to the dollar.

Events in US credit markets have created two questions locally. First, to what extent will the US sub-prime crisis be felt in this region, and second, is there any reason to believe that we may have a credit crunch of our own here in Dubai.

The answer to both questions is "probably not." At least, not yet.

Shahzad Shahbaz, CEO of National Bank of Dubai (NBD) Investment Bank, Ltd, thinks any local impact, if any, will be limited.

Mostly, he says, it could be felt by institutions and high net worth individuals who invested in sub-prime portfolios (see box) or related financial instruments. "Some exposure, but not significant," he says.

Mones Bazzy, an independent financial consultant and former Regional Director with Merrill Lynch, agrees that the Middle East has some exposure, but nothing significant.

However, Bazzy also thinks that the crisis in the US has not played itself out, and the size of the problem remains unknown. "I don't think they know where the end is yet," he says.

His main concern is in hedge funds which usually involve complex investment strategies. "A lot of local investors are in hedge funds," he notes. And that's a concern.

Indeed, some global hedge funds at blue chip investment firms like Bear Stearns, Goldman Sachs and Citigroup were hard hit.

The effects also backed up on real estate dependent companies in the US like The Home Depot which sells construction supplies. Even mining and metals companies with only the vaguest connection to mortgage lending felt the impact.

A broader issue is whether or not the fallout from the credit crunch pushes the US economy into recession. This possibility causes Frédéric Buzaré, Global Head of Fundamental Equity Management at Dexia Asset Management, to worry that this might lead to a decline in oil prices, a topic that rivets everyone's attention in GCC countries.

Buzaré says, "If history is any guide, expectations of an economic slowdown in the US should lead to a softening oil price." That could hurt local financial markets. "Equity markets in the Middle East are vulnerable to profit taking," he observes.

Cost of credit

The US sub-prime situation is a crisis of confidence, says Shahbaz, as well as a "tightening of credit spreads." What he means is that the profitability of financial portfolios based on sub-prime loans has decreased. The risk of these investments is the same, he notes, but now the price associated with that risk is higher.

In other words, investors are demanding more return for their willingness to invest in these portfolios. That has made finding investors more difficult and has caused, in the words of one observer, "liquidity to evaporate."

It also sent the central banks in the US, Europe and Japan scrambling to inject liquidity into finance markets, with mixed results. In the US, in particular, central bankers are acutely aware that their's is a debt economy. Any slump in economic growth makes lenders vulnerable, as would high levels of inflation.

This will clearly have an impact on the UAE Shahbaz notes, because it means borrowing will cost more, whether the money is coming from local investors or overseas financial institutions.

This impact is likely to be felt mostly by large corporations, basically what financiers call the wholesale end of the business, rather than the retail divisions which focus on consumers. The crisis of confidence has caused "risk to be re-priced" starting with large borrowers and moving down.

Shahbaz thinks that there's another side to the issue when seen from a local perspective. Already, real estate prices have flattened out in the US.

In fact, it was the slowing of the real estate market that triggered the credit crisis. As the effect seeps through the economy, real estate prices could fall further. This could very well create lucrative opportunities to invest at bargain prices.

For cash-flush local investors, the watchword is "buy." Those purchases could also include portfolios of sub-prime and other financial instruments which other more risk-averse investors are now avoiding.

Sellers could be US and other financial institutions which would rather get these portfolios off their books at a modest gain, or even loss. That would be better than having to answer embarrassing questions from shareholders and investors.

Sub-prime credit is a sophisticated version of a home loan, and requires the ability to collect credit data on consumers, and then analyse that information to determine the level of risk involved for a given consumer. Once that risk can be accurately measured, then credit can be priced accordingly.

What this means is that consumers who are good credit risks - pay their bills on time, have job stability and so forth - pay less to borrow money. Those who are poor credit risks - sub-prime borrowers - pay more.

But, the UAE is a totally different situation, says Shahbaz. "We don't have a sub-prime category." The reason is that the credit monitoring business is just getting underway here.

Earlier this year, Dubai-based Emcredit was launched and is only just beginning operations. The Central Bank of the UAE is creating a national credit bureau for similar purposes. But, to date, not enough information is available to allow meaningful credit pricing.

That doesn't mean that unwise loans are not made by local banks. Increasingly, properties are being offered at only one per cent down, for example, and that is enticing people to buy who may not have adequate financial strength to pay in the future.

Sub-prime lending is a very aggressive lending practice, says Bazzy, and the UAE is headed in that direction.

But whether the UAE technically has a sub-prime market is a semantic issue. If bad loans are being made, and an economic correction were experienced, an increase in defaults would be the likely result. That could be really tricky with the high proportion of expatriate borrowers.

Even in the US, where law enforcement officials can prosecute most borrowers, home owners will sometimes walk away from a property when they owe more than the property is worth.

Rather than come up with the money to "get out from under the property," a borrower will allow the loan to default and the property foreclosed upon. See inset for a default scenario.

In the UAE, that becomes a bigger concern when one considers that expatriates make up a huge share of the real estate market. Understandably, bankers in the UAE have attempted to protect their investments by having expatriates sign undated checks.

The idea is that if an expatriate defaults or loses his job, the check can be cashed against the expatriate's bank-held assets to cover the amount owed. If not enough financial resources are available to cover the check, then criminal charges are possible. Criminal, as in jail time.

It's hard to say how much consumption-crazed expatriates understand about the implications when they sign an undated check. Some might claim that the system smacks of entrapment, setting your own customer up for a nasty legal situation. That is not likely to help banks win customer service awards.

Economic growth

The undated check system is cute and might look good on paper. But it won't work.

If the time ever comes when expatriate defaults on local mortgages were to increase significantly, headline-hungry news editors the world over will have a field day: 'Expatriates jailed for defaulting on luxury villas. Or how about, Expatriate detained by legal authorities for debt default while attempting to return home for life-saving medical treatment.'

The technical term for this is "major public relations disaster." And one that is wholly unneeded by a city wishing to distinguish itself for its ability to attract top global knowledge worker talent.

It's time to go back to the drawing board and rethink the system. Professional managers always plan for the downside, even if they are currently enjoying the fruits of an upswing.

Bazzy believes the issue is academic for now. The practice of lending to risky buyers is not widespread in the UAE, he says. Even when personal loans are considered, this activity represents only a small part of the economy.

But that is rapidly changing. Over the past year, the value of mortgages in the UAE has almost doubled to Dh45.7 billion, Reuters recently reported. Plus, Dubai's population is growing at 7.9 per cent a year, an increase of perhaps 358,000 people between now and 2010.

That number could be as high as a half million, investment banking firm EFG-Hermes thinks. At the same time, 277,000 new residential housing units are expected to come onto the market, mostly in 2009 and mid-2010.

"What happened was good," says Bazzy, referring to the sub-prime credit crunch, because it forced bankers to examine their portfolios. Plus, he notes, the economic situations in the US and UAE are very different. He agrees that the US crisis may be an opportunity for local investors to acquire assets at attractive prices.

Whether sub-prime is introduced into the UAE or not is beside the point. The main issues, says Shahbaz, are that local financial markets have high quality information to work with, good underwriting practices and conduct lending practices diligently. "This is the message that needs to be reinforced."

What is sub-prime lending?

What is sub-prime lending? In western housing markets like the US, a sub-prime borrower is someone with a relatively low credit rating. That person may be slow paying his or her financial obligations. Or he may have a great deal of available credit, even if that credit is not being used, suggesting the potential for problems.

If a person inquires frequently about obtaining credit for a personal loan, or for an auto or home, whether or not the money is ever borrowed, that lowers his credit rating.

All this information and more are collected by credit bureaus in the US. The result is an enormous reservoir of information about who pays their bills and who does not. From this data, credit bureaus calculate a credit score, which basically grades a consumer on is creditworthiness.

An "A" borrower is one with the best credit score. Sub-prime borrowers have lower scores, but still within an acceptable range. Investors are willing to lend to borrowers whether "A" or sub-prime, but they will charge sub-prime borrowers more.

The reason is that these borrowers are riskier. A basic axiom in finance is that the riskier the investment, the higher the reward must be.

In fact, sub-prime loans are generally considered to be a lucrative investment because investors pay so much interest. This, of course, attracts investors.

In the US and even in the UK, where concerns about a sub-prime crisis also exist, problems have been exacerbated by sloppy lending habits. Many loans are arranged by mortgage brokers who put borrowers into unsuitable loan programs because they earn high commissions.

The problem is that sub-prime borrowers tend to be the weakest link in the economic chain, with few cash reserves and often low paying jobs. In January, for example, 14 per cent of US sub-prime borrowers were more than 60 days overdue on their loan payments.

As long as the economy is good, and home prices are rising, mortgage payments keep rolling in and investors continue earning their profits.

In the US, home prices have been rising aggressively for years. Now, that has slowed considerably which means that if a home owner is forced to sell, he may not be able to get his money back much less any return.

In some cases, the homeowner just walks away from the property. The loan on the house is then in default, and the bank or other lender may have to foreclose to recover their money.

If homeowners are not paying their loans, then the investors are not getting their profit, and may even lose some of the money they have invested.

Rod Monger is a business professor at American University in Dubai. He can be contacted on business@gulfnews.com.