Worst of US sub-prime probably over

The worst effects stemming from the sub-prime mortgage crisis have probably been wrung out of US financial system.

That is the assessment of Charles Schell, a professor at the University of Manchester and a consultant to the Canadian government on the US economy who was in Singapore recently. He is also the co-author of a book, Corporate Credit Analysis.

Schell admits however that the extent of exposure of non-American financial institutions – such as those in China – might not be as clear. European banks for their part, like Northern Rock in the United Kingdom have so far been propped up by their central banks.

The reason for his views regarding US banks is that most institutions take what he calls the Big Bath approach to clearing the bad debts in their books.

"Whatever the bad news, they will be put upfront. That way, if the sub-par loans do not turn out as bad as initially thought, they could always re-capitalise them and consider them as profitable when they do not turn out to be as bad as once thought."

"That has been a common practice and it's still been done today. Better to take the hit and bad losses now, and get better returns later," says Schell.

He estimates that the total value of the sub-prime loans to be about US$1 trillion., and that Bear Stearns which was rescued from by a $2.4 billion bailout engineered by the US Federal Reserve had probably accounted for most of the 'higher quality' sub-prime loans.

Schell adds that in all probability, it's likely that most of the poorer quality loans which had been sliced and diced into other financial instruments are now in the hands of individual investors especially doctors and dentists and U.S municipals, much like what transpired during the junk bond fiasco in the 1990s.

As to whether the Fed should be blamed for the sub-prime crisis, he points out that while the US central bank could have tightened credit (rather than what former chairman Alan Greenspan did to sharply reduce interest rates) it has only jurisdiction over commercial but not investment banks like Bear Stearns. Much like how state banks were not under the scope of the Fed during the Savings & Loans bank crisis in the 1980s.

Rather the problem stems from the Community Reinvestment Act (CRA) in which the US government encourages banks to make loans in poor neighbourhoods even if the applicants are not considered prime borrowers.

"The Act has nothing to do with bankers in that it was put together by a coalition of real estate people and US legislators to try to raise the percentage of American homeowners from 63% to 69% over a period of three years. It made it easier for first-time buyers to get access to loans."

Up until 1995 the Community Reinvestment Act was largely a requirement to support community groups in poor neighbourhoods. But after 1995 the scope of the law was dramatically increased and modified in such a way that it gave far more power to the federal government to prod banks into lending more widely in poor neighbourhoods.

"But since it was not possible to increase the housing supply in such a short time, the result was that it led to increases in home prices. So much of the liquidity in America really went to raising home prices."

"It led to a culture where many thought prices would not go down and end up over borrowing. Such a situation is not new. It also happened in the UK during the 1990s," Schell notes.

Neither are mortgage securities, which has been in existence since the 1970s.

"There is nothing wrong with mortgage securities by themselves. What it does is to create a pool of home mortgages that became part of collateralised debt obligations (CDO), which banks would sell to investors like non-bank entities, hedge funds and municipalities. These allow the banks to create additional liquidity to service more loans."

Schell explains that most of the time, the CDOs would be bundled together with some form of insurance protection such as credit default swaps (CDS). "Unless, something very bad happens like a 20% to 30% fall in the value, there is always enough to cover the risks."

Such financial arrangements are not only made with housing loans but also credit card receivables, student and car loans. Most CDOs work very well as they are very liquid and rarely ever default.

The problem with Bear Stearns, notes Schell, was that it was holding the bulk of the sub-prime CDOs and CDS at the time when concerns over sub-prime mortgages surfaced and then escalated, leading to a drying up of liquidity for such products.

He adds that with the fiscal measures taken by the Bush Administration and monetary policies by the Fed – depending on the degree of intervention – it's likely that the U.S. will not plunge into a deep recession, but could face a prolonged period of slower economic growth that might last at least a couple of years. By which time, China may overtake the US as the prime mover for global economic growth.

In his view, the biggest threat to the world today is not the banking system but rather the threat of food inflation, which affects much more people than financial crises.

Such fears can topple weaker governments and spill over into both economic and political chaos. In this aspect, Schell says it would be in the best interest of oil economies to try to keep oil prices down as the agriculture industry is a very energy-driven business.