Even a year and half ago, the US economy was on the up with GDP growth rocking at 3.5 per cent. True, the current account deficit was a staggering $800 billion; and there were 17 consecutive interest rate hikes by the Federal Reserve. Yet, banks continued loaning to virtually anyone who wore clothes. Consequently, even in January 2006, there were 2.27 million housing starts in the USA — its highest in many years.

So long as the economy grew, so too did the value of houses. Since home equity was rising merrily, banks became less fussy about whom they lent against home mortgages. Borrowers with dodgy credit ratings and poor income streams were disbursed mortgage-backed home loans at higher interest rates — on the ground that the rising value of property more than offset the credit risk.

Bankers don’t hold mortgages till maturity. They create mortgage backed securities or collateralised debt obligations (CDOs) which are sold to other banks and financial institutions. The sellers get cash; the buyers get a stream of interest payments defined by the terms of the security and their seniority in the debt structure. The housing boom in the US since January 2003 created many trillions of dollars of CDOs that were bought as assets by banks and financial institutions throughout the developed world.

What goes up must come down. Soon enough, the Fed rate hikes started to bite, and the first casualty was housing. By April 2006, the rate of growth of new homes turned negative. It has remained so for every month since — with negative growth rates now in large double-digits. The fall in demand for housing resulted in an even more precipitous fall in home values. This triggered two things: first, the beginnings of home loan defaults, especially in the sub-prime category; and second, the fall in value of sub-prime mortgage backed securities and CDOs. Marked to market, banks holding these instruments had to reckon with big hits on their asset book.

Then came the first sign of panic. It happened this month in the United Kingdom with a home-loan bank called Northern Rock, which is chaired by Matt Ridley, one of Britain’s best science writer and the author of the best-seller called Genome. Northern Rock’s large stock of CDOs had started to default; and when marked to market, the bank just didn’t have adequate capital to cover its deposits. Amidst anxious negotiations between Northern Rock, the Financial Services Authority, the Treasury and the Bank of England, depositors got wind of the problem and began to queue up to withdraw their money. Screaming headlines and pictures of thousands of panicky depositors snaking round the block was too much for Prime Minister Gordon Brown and his Chancellor of Exchequer, Alistair Darling, to stomach. They immediately decided to protect all deposits in the UK — not just those of Northern Rock. While in theory, this has converted private liabilities to contingent public debt, it poured oil on troubled waters. The depositors went home.

Is this the end of the sub-prime crisis? I fear not. There are probably a dozen to twenty state-level banks in the US that are overstocked with CDOs which, if properly marked to market, will lead to major hits in their already stretched balance sheet. Moreover, there is enough evidence to suggest that a few large enough banks in Europe are also overloaded with CDOs and haven’t yet marked their rapidly declining assets to market. Unless the US housing market suddenly picks up and heads resolutely north — and nobody sees that happening in the near future — I believe the world will some more bank shakeouts. And they could be more serious than Northern Rock.

Thankfully, India is immune to this potential crisis. Except in one way. If there were to be a simultaneous implosion involving three or four large banks, you can be sure of a global liquidity squeeze. That can affect our markets, portfolio inflows and the ability to finance global acquisitions. Otherwise, we are in safe harbour. For once, thank the Lord for our tougher lending regulations.

Published: Business World, September 2007