Effects of the U.S. sub-prime crisis

It has been five months since the onset of the financial crisis in the U.S. brought about by the default of the loans that the Banks granted to less than creditworthy borrowers, i.e. sub-prime borrowers.  Still the problem has not been resolved even with the Federal Reserve Banks and the European Central Banks injecting liquidity into the system by offering cheap inter-bank loans, and standing by to bail out any troubled banks. Citibank, HSBC, Bank of America, UBS, and a number of Wall street investment banks have already declared and recognized their losses due to the write down of the value of their Collateralized Debt Obligations (CDO’s), while the Abu Dhabi Emir had already infused $7.5 billion to Citibank. Pres. Bush has announced a bailout package for troubled sub-prime borrowers, which was concurred by ex-Federal Reserve Chairman Greenspan. The president of Citibank and of a European bank had already lost their jobs and yet the crisis has not ended. Why?

 To know why it is taking so long and what are the effects, we have to understand the nature and magnitude of the problem. As to magnitude: recent estimates have put the sub-prime mortgage size at $450 billion, with Citibank and HSBC each taking a $40 billion hit.  In relation to the total size of the U.S. economy and the European community, which are in trillion dollars, this would be manageable and comparable to the Asian crisis in 1998, which is now a thing of the past. So, over time, as in the Asian debt crisis, this will be resolved.

The nature of this sub-prime crisis is a little more complicated and involves more active participants than the Asian debt crisis. In the latter case, the defaulting borrowers were mostly governments and large corporations, while in the former, the borrowers are individual American  homeowners. There is certainly more emotional dimension in the case of the sub-prime borrowers. We have to remember that most of the sub-prime borrowers were enticed by mortgage brokers or the banks to borrow with very little equity on the houses, with the expectation that with the low interest and the prospect of rising house prices, they will eventually have enough rental income to pay the amortization, or sell the house at a higher price. Then the bright guys in Wall Street and in the banks, had this idea packaging all these mortgage loans into a debt instrument, the Collateralized Debt Obligation (CDO), and selling these as securities backed by mortgages, to other banks, financial institutions, and other investors all over the world at very good yields which made them very attractive, supposedly safe investments. Then the household borrowers started defaulting and the whole thing unraveled. These securities are now worth less than 40 percent of what was paid for them. 

The effect on the banks over and above the losses that they have to recognize as the value of these mortgage loans that are devalued, is that they have become stricter in lending or acquiring mortgage loans. So, even if they can source cheap funds from the Federal Reserve Banks, they would not be able to deploy enough of  these funds at yields that will be profitable. The alternative of putting them in sovereign Bonds of countries will also drive the yields down, so they will have to look for Bonds of countries with less than prime credit ratings, which they are wont to do after getting burned in the sub-prime mortgages. The Philippine banks, due to the limits on foreign currency investments, have very little CDO investments, and  significant amounts are with guarantees so that very small losses were recognized by Philippine banks.

The macro-effect of this sub-prime crisis is the weakening of the U.S. dollar against almost all currencies. The dollar has lost 20 percent in value against the peso in eight months, 10 percent against the Renminbi in 12 months, and at various percentages against the oil countries currencies. So, the OPEC members are complaining and increasing the oil prices to what the market can bear to compensate for their exchange losses. The U.S. economy due to its size, diversity and resilience has not yet buckled down, but there is already a psychological tendency which could materialize.  Easy money and other pump priming monetary policy will likely prevent a meltdown, but the slower “housing starts,” which is a major indicator of the health of the U.S. economy, will certainly reduce the growth of the economy. And when the U.S. economy slows down, half of the countries in the world also slows down to the extent that their economies are connected to the U.S. in terms of trade and investments.

No doubt the U.S. and the world will survive this crisis, but some will fare better than others. The Philippines will not be most affected as it is enjoying a 7 percent growth rate in 2006 and 2007. At worst, it could bring down our GDP growth rate to 5 percent, which is bad but not a disaster.

There are many lessons to be learned from this debacle, but what immediately came to mind is that those hotshot/bright boys in Wall Street and in the world’s biggest banks are as fallible and as susceptible to error like everybody else. When they lose money, they lose big, and most of the time it is other people’s money. Expert opinion is valuable and is needed. You just have to be sure to have the right expert. Most of all, financial literacy and understanding is important to anyone with substantial investment funds to be able to evaluate investment options or even just to evaluate the experts.