Subprime mindset

Thursday saw another expression of global market nervousness, due to changes in the US "sub-prime market". Listening to stories about sub-prime securitised house loans in America is a bit strange in the Indian context — it's like a remote village trying to make sense of an event in the national capital.

India is still a financial market amateur. Over the last few years we have barely managed to gain familiarity with EMIs and home loans. And home loans in India are still not pervasive. Most households are excluded from the home loan market. Those with a high probability of default are simply not given loans. Exclusion from the home loan market is the norm for the bulk of the poor. Even when loans are given, they are given by banks. The risk is on the balance sheet of banks and ultimately of the public that deposits its money in banks. If borrowers default, it is the bank that gets hit.

Home loans in developed financial markets are more complex. Thousands of home loans get bundled together through a process called securitisation. These securitised bundles are then cut up into assets with different grades of risk. The transformation of risk takes place twice. First, pooling thousands of loans into a diversified portfolio yields a reduction in risk through diversification, in a manner similar to that found in insurance. Second, the pooled portfolio is then cut up into high-risk and low-risk grades, which are separately traded. When loans are repaid, the first people to get paid are those, like pension funds, who bought the low-risk assets and whose returns are also lower. Those who could afford to take on more risk, like hedge funds which cater to rich clients in the hope of getting higher returns buy the high risk assets. In the event of defaults, they are the ones who get hit. The clever financial innovation of splitting the risk allows the pensioner who does not like to take risks to get a small monthly cheque regularly, while the rich client who chooses high-risk and high-return assets makes money when the market does well, and loses when it goes down. The best thing about this innovation is perhaps that the losers are those who can afford to lose, who are prepared to lose and therefore bought the high-risk assets. So, when a worker loses his job and defaults on his housing loan, the pensioner does not suffer, the rich hedge fund client does.

... contd.

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