Mohamed A. Ramady
Publication Date: 
Mon, 2007-04-09 03:00

Ben Bernanke is a mild mannered man, and the US Federal Reserve chairman normally chooses his words very carefully, knowing the potential impact on both US and world markets. He was not amused to say the least, about his predecessor’s comments in early March, about the possibility of a US recession later this year. Some put it down to the difference between the Greenspan of now and the Greenspan of then, when he was chairman of the Federal Reserve, is that he can now say what he thinks, as opposed to what he thinks he ought to say.

Bernanke has not retired yet and hence his comments that the “uncertainty” about the outlook for the US economy has increased, only added to already frayed investor nervousness, with the Dow Jones index falling 100 points in one day. What made the Fed chairman so worried to break his hermetic silence? The problem it seems, are the after shock effects of the so-called US subprime housing market.

Bernanke’s actual words were as follows, that “at this juncture, the impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained.” So far, so good. What was the issue then? The troubles, which had hit some of the biggest mortgage lenders in the US had raised, according to the Fed Chairman, “some additional questions about the housing market. Near term prospects for the housing market remains uncertain.”

And there we have it in a nutshell. There are now genuine fears on Wall Street, that both consumers and businesses will spend less as economic uncertainties gather pace. In his testimony to Congress, Bernanke seemed to contradict the Fed’s current neutral stance on monetary policy — with interest rates remaining unchanged at the last Open Market Committee Meeting — by saying that inflationary risks in the US remained. Just to add another measure of uncertainty to the market’s inflation forecasts, oil prices rose sharply on Iran related tensions.

It is the US housing market, or more specifically, the so-called subprime market, which remains the main focus of concern. These are home loans extended to those with low incomes and poor credit ratings, and the fear is that loans that seemed to have been extended with reckless abandon even by normally prudent banks, will come back to haunt Wall Street, as borrowers become unable to repay these loans. The amount of outstanding subprime mortgage loans is nothing to be sneezed at — totaling $1.3 trillion, or equivalent in size to the economy of California, or nearer home, to nearly four times the size of Saudi Arabia’s 2006 gross domestic product (GDP). It is now feared that one-in-five subprime loans are likely to end up in default. One of the largest US institutions involved in this market, New Century Financial, has just filed for Chapter 11 bankruptcy protection. This is bad news for all those that eagerly entered this peculiar US mortgage market, including it seems, prime UK banks such as Barclays and HSBC. The latter has been struggling with bad debt provisions for 2006 in the US, ever since it bought subprime lender Household International, which it renamed HSBC Finance. Earlier in March, HSBC revealed that its bad debt provisions for 2006 would be about $10.5 billion — largely because of mortgage default. The result was that some of HSBC’s top US executives, including its North America CEO Mehta, quit the bank.

How did Wall Street come to this sorry state of affairs? What happened is that a few years ago, when interest rates were at historically low levels, and the US financial market was flooded with cash, lenders were keen to make loans and allowed people to take out mortgages when their earnings were not enough to keep up with payments. Secondly, the subprime mortgages routinely included features that seemed to increase the risk of default, such as adjustable interest rates and loans with limited documentation. The dominant type of subprime loan was the so-called “2/28” mortgage, that featured a semi-annual interest rate adjustment, after a two-year fixed rate period. To make matters worse, the initial fixed rate is often discounted, or a “teaser” rate, so the eventual rate adjustment leads to significantly higher payments.

Should we be worried, along with Wall Street? Definitely yes, as slower growth in the US will have an impact on the rest of the world in several ways. Firstly, financial markets, which are now more interlinked globally, will remain jittery on who exactly is being affected by bad loans, and if they have enough cushion to absorb large debt write-offs. Secondly, the US market is still the single most important market for many countries’ exports. Any slowdown there, will affect global economic growth, despite some attempts at market diversification by some countries. In the meantime, the US asset bubble remains a shadow over all.

Should we feel sorry for Wall Street? Definitely not. A lot of analysts are now scathing about the greed shown by financial institutions in tempting the most vulnerable sections of society to apply for such loans , calculating that they could pick up property on the cheap if loans are foreclosed. The financial institutions tried to protect themselves too — by bundling and repackaging such mortgages and selling them in the secondary markets as sophisticated capital market instruments. In essence, they were passing the buck to other institutions, and hence the Fed chairman’s sleepless nights. Maybe this is also a good time to send some of the financial high flyers to refresher Real Estate Finance 101 level courses...

What are the lessons for Saudi Arabia and the Gulf countries? Saudi banks are toying with the idea of establishing fully fledged mortgage lending entities, and some in the Gulf, such as Dubai, have already done so. Such institutions have to tread with caution and learn from others’ experiences and mistakes, especially in borrowers’ credit, risk evaluation and appropriate documentation. People though, sometimes never learn, as evidenced by the collective amnesia that Saudi stock market investors had concerning the more recent regional stock market crashes. Let us hope the same does not happen to emerging Gulf mortgage markets, and that local regulators take note of Bernanke’s current nightmarish headaches...

(Mohamed A. Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.)

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