By now, everyone is aware of the hits taken by the US banks and financial institutions on account of sub-prime mortgages and collateralised debt obligations (CDOs). Everyone expects more hits in the coming months, with the total write-down in the US to be around $ 450 billion. What has caught the market unaware is the additional hit that the system may have to take on account of monoline bond insurers.

US bonds need their credit risks to be underwritten by insurers. There are some insurers called the monolines, who ‘rent’ their AAA ratings to underwrite municipal bonds. Since municipal bonds are very safe, it is a good model: small capital base, AAA ratings, underwriting tons of safe papers for small fees resulting in good profits. In the aggregate, the monolines underwrite some $ 2.5 trillion of debt.

During the sub-prime and CDO frenzy, some monolines got lured by higher fees, and began underwriting sub-prime paper and related CDOs. For instance, the Ambac Financial Group had a direct exposure of $ 8.8 billion in sub-prime mortgage backed securities and another $ 29 billion in CDOs. MBIA, another monoline, had an exposure of $ 5 billion in sub-prime paper, and $ 25 billion in CDOs. As defaults rose, so too did the losses of these firms. In Q4, 2007, Ambac lost $ 3.26 billion loss; and MBIA wrote down assets by $ 5.3 billion.

Given these large losses and relatively thin capital bases, the monolines are hard-pressed to re-capitalise — and face ratings downgrades. For instance, Fitch has already reduced Ambac’s rating from AAA to AA. This downgrade creates systemic problems. When an insurer’s credit rating is downgraded, so too is the rating of all the bonds that it has insured. Hence, for each monoline getting a lower rating, there is an identical downgrading of all the bonds underwritten by it —involving several billions of dollars. That, in turn, triggers mark-to-market losses of all institutions holding such bonds. Bloomberg estimates that a downgrade from AAA to AA can cost up to $ 200 billion in market-to-market losses. That is huge and unanticipated.

Now on to the RBI policy — which maintained status quo on the bank rate, repo and reverse repo and the CRR. The RBI is a sound institution. However, sometimes even the best make mistakes, and this time the RBI has erred in not loosening interest rates. Why?

First, interest rate arbitrage. At end-November 2007, the interest rate on 3-month US treasury bills was 4.4 per cent, versus 7.50 per cent on Indian G-sec. With the 125 basis point Fed cuts, interest on 3-month T-bills has dropped to 2.83 per cent, while 3-month Indian G-SECs are ruling at 7.17 per cent. The arbitrage opportunity has widened dramatically, and will encourage global investors to borrow in dollars to invest in rupee bearing instruments. That will exert stronger pressure on appreciating the rupee.

Second, high real interest rates. The prime lending rate (PLR) is between 12.75% and 13.25%. At today’s cost of living inflation of 5.1%, this is one of the highest real rates in emerging economies. Thousands of small and medium businesses who borrow at, or over, PLR are hurting very badly.

Third, investments and corporate profits. The results of Q3, 2007-08 show that sales and profits are down for many manufacturing firms. Also, with higher interest rates and various bans on ECB, many companies are postponing or paring investment decisions. With industry running at full capacity, this is something that India cannot afford.

Fourth, India will achieve lower growth in 2008-09 — most likely 8 per cent, with a possibility of it going down to 7.5 per cent. Already, growth in the three-month moving average of the Index of Industrial Production has come down from 13.5% in January 2007 to 8% in November. Construction growth is also down. Anything that facilitates growth is welcome. The RBI’s status quo has not helped.

Finally, the RBI’s extreme stance inflation. The RBI clearly stated that inflation was down according to all measures: Wholesale price inflation down to 3.8 per cent; manufacturing inflation down to 3.9 per cent; and each CPI-based inflation was down. Yet the RBI believed that there were “upside inflationary risks in the period ahead”. Keeping interest rates high and choking growth because of an ultra-monetarist fear of inflation is not what India needed today. Pity that the RBI thought otherwise.

 Published: Business Standard, February 2008