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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

We all are responsible for this subprime mess

The tsunami of US Subprime problem has been wrecking havoc in the financial markets across the world. Almost every investor, whether in debt, equity, currency or commodities is likely to be affected by it.

On the face of it, this is an issue local to US markets (yes its’ impact is worldwide as the markets today are globally interrelated). However, on a deeper level, we all are equally responsible for it.

What is this Subprime problem?
In very simple terms, subprime loan is lending to people, who may otherwise not be eligible for a loan under normal circumstances. Maybe they don’t have a regular job or income. Or they have been defaulters in the past. Therefore, generally banks won’t lend to such “high-risk” borrowers.

But banks in US did start lending to this high-risk category; and since the risk of default was high, they charged a higher interest rate.

To some extent this lending was OK, as these loans were mainly backed by mortgage of the property financed. So, if the borrowers defaulted, banks could always confiscate the property, sell it and recover their loan.

But they made some mistakes. They went overboard with it with no respect for prudential norms. Also, they did not adequately factor in for the fall in property prices. As the Fed started increasing the interest rates, these subprime borrowers started defaulting. As more and more properties came into the market for selling, the property prices fell. As it is the higher interest rates had affected demand even from the prime borrowers. This additional selling compounded the problem.

Thus with sharp fall in property prices, banks could not recover their loan and many firms which specialized in the mortgage business started collapsing and closing shop.

Why did this problem spread across the world?
It is common for banks to combine many such small loans and create one debt, which can then be sold to other investors. This helps them to raise more money for fresh lending. (In financial terms this is called securitization).

Many such small loans – both prime and subprime – were securitized and sold to investors all across the world. Since, these offered higher interest rates and were backed by security of the property, insurance companies, pension funds, hedge funds, etc. invested heavily into such securitized debts.

Since the investors today are spread across the world, the default problem in US is having its’ effect worldwide.

Even those lenders/investors, that have no direct stake in subprime loans, are affected as people are becoming more cautious. They are even calling back the loans which may not be bad or getting out of the riskier emerging markets. All this is putting pressure on the financial system. Hence the problem is having a widespread impact.

So what’s the lesson here?
We need to look at this problem from a broader perspective.

Why did banks lend to subprime borrowers despite knowing that there could be a high rate of default? Doesn’t it go against the basic tenets of lending? The reason was simple – Greed.

It was the greed of earning higher interest rates when the normal rates in the markets were at historical low. It was the greed for short-term profits, compromising the long-term future. It was the greed for annual bonuses. It was the greed for high share prices of their banks, where they had their own stake too.

Even the various funds were motivated by greed. These weren’t lay investors who usually get fooled into making bad investments. These all were well-qualified and experienced professionals. Surely, they didn’t forget the basic principle of finance – high rate means higher risk! They too were more concerned about short-term profits and their annual bonuses.

Aren’t we too doing the same thing? Aren’t we expecting to earn 40-50% p.a. returns? Aren’t we always demanding companies to deliver better and better results, quarter on quarter? Aren’t we forcing the managers to look for short-term profits rather than long-term growth? Aren’t we punishing companies like Tata, Birla etc. who are acquiring companies abroad for their long-term growth? Is our vision of tomorrow’s profits more important than Ratan Tata’s or Kumaramangalam Birla’s long term vision?

As Warren Buffet’s says that it would be much better if we stopped looking at the stock tickers day-in and day-out. If there we no market quotations we would not be affected by the daily movement of stock prices and let our investment grow with time.

But I think we have either forgotten his philosophy or simply think it to be outdated in today’s world. If we are doing so, we will have to pay for it.

We are paying the price in the form of subprime problem today. We have paid this price for greed many times in the past whether it was dotcom mania or the Harshad Mehta/Ketan Parekh scam or the plantation companies or the vanishing companies or the Enron/Worldcomm collapse etc.

The lesson is very clear. But unfortunately we have very short memories. Some time from now we will be back to our greedy ways and again pay the price in some different form. As is commonly said if we forget the history, we will be condemned to repeat it.


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