Sub-prime crisis

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The sub-prime crisis is now presented as the villain of US economy as also the global economic scene. The issue has ceaselessly figured in news headlines all over the world. Millions of bytes in the print media and thousands of hours of visual media have been devoted to dissecting the crisis. The crisis is being analysed and its fallout discussed in the discourse of the US and global experts and establishment.


But the real story about the economic thinking that led to this crisis is yet to figure in public discourse. That is about the greedy and uneconomic economic model that philosophised sub-prime lending that led to the crisis, as indeed it was bound to. This crisis is the latest part of the continuing story of the economics of greed wrapped as modern economics. It is scripted by mortgage-lenders, underwriters, commercial and investment banks, rating agencies, pension and other funds.

In this enterprise, in which the US’ entire financial architecture – the government and the Fed included – is involved, borders on criminal breach of trust against those whose money has been squandered. The FBI is already on the trail, sniffing for criminal activity in sub-prime lending. This latest story of gluttonous economics – the sub-prime lending chapter – is fascinating, but its implications equally frightening.

Cheap money

For the benefit of those joining the discourse late, sub-prime lending refers to loans given to persons who, in simple terms, are unfit to borrow. That is, no lender will part with his own money to such a borrower. But, then, why did such lending take place, particularly in US – the country that sermonises on financial prudence to the entire world? For two reasons.

First, such lending was popularised from the White House to ordinary American homes as achieving a noble purpose, namely, it was necessary, as the unfolding story reveals, to induce Americans to borrow and shop for their country. That is, it was part of the patriotic duty the Americans as a whole to borrow and shop.

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Second, the sub-prime lenders were handing out, not their own, but others’, money. It was predatory lending more than predatory borrowing that seeded and fertilised the sub-prime crisis. The lending was executed through a host of players, including the gullible borrowers, all of whom acted in concert to realise the higher philosophy of spending beyond means to save America. But how did private spending by borrowing become public good? Read on.

The US economy had generated cheap money through the dotcom bubble in the late 1990s and had gone on a high-growth mode. But, as the third millennium opened, the dotcom hopes collapsed and recession set in. The terror attack on US in September 2001 coincided with the recession. To come out of the mess, the US, as also the rest of the West, which had virtually become its appendage, needed some outlandish ideas to get on with life shattered by recession and terror.

New patriotism

The desperate and crisis management ideas generated then, including the predatory sub-prime lending, soon became a durable part of economic modelling in the years that followed. This is how the Time Europe magazine (January 28, 2008) captures what happened then and later. “Since September 11, 2001, consumerism has been cast as new patriotism” it said.

The former President, Bill Clinton, urged his countrymen “to get out and shop” and congressmen “to take news crews on expedition to suburban malls, to lead by example”. A Georgia group called ‘Moms of America’ even declared September 30 “Shop-for-America Day”. Investopedia, a Forbes Media Company, said, “the idea of spending was patriotic was widely propagated and everyone, from White House down to local parent-teacher association. It worked, and the economy began to expand in the year 2002.”

Time magazine says, within two weeks of the attacks, General Motors exhorted television viewers “to keep America rolling” by taking advantage of its 0 per cent financial offer. Result? A quantum jump of 7 per cent in retail sales for October 2001; most retail spend was accounted by auto sales; the auto-makers cleared all their un-sold and unsaleable stocks. That what is good for General Motors is good for America stood affirmed again! Thus, collectivised greed was taught as the philosophy of need.

But, how did Americans find money to fulfil their national duty to shop for America? The whole system stepped in. The US Fed devised almost a no interest policy by cutting the interest to 1 per cent. Said Investopedia: “This forced the investors to seek returns through riskier investments and lenders took even greater risks.”

Thus was born as a solution to the problem of recession the sub-prime mortgage lending on houses. With the sudden rush of cheap money chasing houses, house prices shot up by 6 per cent in 2003, 8 per cent in 2004, 14 per cent in 2005, 13 per cent in 2006. How did rise of house values promote spending? This was how.

Take, as illustration, case of Stockton, a California suburb. Carrigan, the town’s development in-charge says: “People went to the bank and got loans against the increased price of their house. They went out and spent all that money. The prices of houses went up again. They went back to the bank and got another loan. They spent the money on cars, jewellery and furniture – whatever they wanted. End? People in Stockton spent their house.” (BBC World Service December 30, 2007).

Not just Stockton, the whole nation did precisely that. As the interest rate was cut and more people bought houses, the value of houses artificially shot up. The owners of houses used the increase in value as additional equity and borrowed and shopped for America!

Encouraged to borrow

The unworthy borrowers, who would have hardly had the guts to borrow, were thus enthused and exhorted to borrow and spend. And for a national cause!

There are varying estimates of how much was lent. And the numbers are startling. So far Americans have borrowed through credit cards $2.46 trillion; through sub-prime mortgages $1.3 trillion; and through other mortgages not regarded as prime another $1.5 trillion – all aggregating to $5.26 trillion.

The crisis hit the sub-prime mortgage loans of $1.3 trillion first, with sub-prime credit cards and sub-prime elements of other mortgages waiting in the queue. These monies have gone through the shopping malls out of the US and to China and elsewhere, driving the global economy in the bargain. This borrowing and spending game is promoted and presented as consumer confidence driving the US and global economies.

But the dotcom crisis, overcome by sub-prime lending, was only deferred. Crisis soon hit the sub-prime mortgage market when the housing bubble burst in the year 2006 when the house prices nosedived by 8 per cent, with estimates showing a further fall of 10 per cent this year. This reduced the security for the loans and with the unworthy borrowers not paying their instalments, there are large foreclosures and consequent write-offs.

The current estimates of the credit loss in sub-prime lending is put at $300-400 billion. More, in the next part, about the financial architecture of the sub-prime lending and how all the players worked together guided only by self-interest without regard to their fiduciary duties, and how the American consumption, which was a global asset has, turned into global write-off of US debt!

QED: An Indian seer who figures in epic Mahabharata, Charuvaka, exhorted the people to borrow, spend and live happily, and not bother about how to repay the debt and not feel guilty if unable to pay it back.

Even though he commended this thousands of years ago, the people of this country continue to disregard his prescriptions till today. But the US economists seem to have patented Charuvaka’s economic theory as theirs. The latest effect of this theory in practice is the sub-prime crisis and losses. The only difference is that the American version is definitely an improvement over Charuvaka’s economics, as it made the borrowers feel that their borrowing and spending was not for themselves, but for America!

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