Recent US economic discourse shows that a big crisis can be postponed by a massive dose of financial steroids, like sub-prime lending, even if it threatens to explode later. And if borrowing to spend is seen as a 'virtue', then toxic sub-prime missions in the US at the cost of 'primitive' savers elsewhere are inevitable, says S. GURUMURTHY

Warren Buffet, the best known US investor, estimates the sub-prime loss at $600 billion, surpassing Goldman Sachs' latest figure of $500 billion. No one says it will not improve further. Mr Ben Bernanke, the US Fed Chief, who underplayed the crisis first and dismissed it as a mere $100-billion affair, seems desperate now. 'Forego your debt in part', he nervously tells the already fidgety mortgage lenders, admitting the depth of the crisis.

Sub-prime crisis has doubtless made the US Fed sleepless. But, paradoxically, the Fed is also proud that consumer loans - knowing that it includes sub-prime loans in new forms - subsequent to the scam have increased indicating that consumer confidence is rising, not falling, and that the economy is unaffected by the scam. Again, paradoxically, the massive loss has not impaired, nor allowed to impede, sub-prime lending as such. New players and innovations in the sub-prime market have replaced the old. That is, only the players have changed but the game is still on!

The new players are encouraged by the fact that old sub-prime losses hit not the retail sub-prime lenders but the greedy banks and hedge funds in Europe, West Asia and Asia.

These banks and funds had invested trust monies of their clients in the consolidated sub-prime mortgage instruments - the Collateralised Debt Obligations (CDOs) rated by 'reliable' rating agencies and floated in the global market by the sophisticated rule-based US financial system - and a good part of the investment is now as good as gone.

It is the erosion in the value of the CDOs at the hands of the distant investors that Warren Buffet estimates at $600 billion as the loss in sub-prime lending. Result, for the bad loans given in the US, a bank in India is making a provision of $200 million-plus in its books, thanks to the CDOs certified by the 'most sophisticated' financial engineer of the world - the US. Post facto, the search for what and who went wrong is still on. But with no clue in sight as yet.

Did wrong mechanics or methods of sub-prime lending force the crisis? Or, was the mission or the philosophy of sub-prime lending itself wrong? Read on for answers that lay buried in the new story that unfolds.

What went wrong

After the sub-prime mortgage players got exposed thus, new ones quickly stepped in to fill the vacuum in the sub-prime market, through other - and worse - forms of such lending, like sub-prime credit cards. Mintel International group, a market research firm, points out that credit card issuers began multiplying their effort to offer credit cards and sign up with - whom? - the very customers who have defaulted on sub-prime mortgages! They mass-mailed card offers to sub-prime defaulters.

Direct mail card offers rose by a whopping 41 per cent in the first half of 2007 over the first half of 2006, with the numbers in June 2007 double that in June 2006! But, and shockingly, direct mailing to those with good credit history fell by 13 per cent. Yes, less new credit to good customers and more to bad ones! But, card issuers are no fools. Lending to defaulters is undoubtedly more profitable.

A sub-prime credit card limit of $250 yields a net credit of only $72 to the borrower, with the balance $178 going as charges to the issuers - namely programme fee $95, account set-up fee $29, annual fee $48, and monthly fee $6 - translating to an annualised interest of 486 per cent - yes 486 per cent - says National Consumer Law Centre, US. It is almost barbaric. US Today (December 7, 2007) said that "bad credit is good business" in the US.

The Consumer Federation of America sees this as "great concern". But the card issuers claim that, "marketing to sub-prime borrowers is a sign of healthy competition" and "the consumers should be grateful" to them for that. So, even as sub-prime mortgages had knocked down the US economy, sub-prime credit cards - which rose by 11.3 per cent "signing off seventh consecutive month of rise" - have come to its rescue. Result, sub-prime lending vehicle has only changed after the crisis - from mortgage to credit cards!

Yet, the US Fed proudly reports that consumer borrowing in December 2007 - obviously aided by bad credit - is up from $5 billion in December 2006 to $7.4 billion in December 2007. A rise of almost 50 per cent. Credit card debt totalled $2.46 trillion till June 2007. Credit card debts are also turned into CDOs and marketed to banks world over, like the mortgage CDOs. Mortgage CDOs are secured, but credit card CDOs, unsupported by collaterals, are not.

The logic

If the card debtors default, CDOs derived from card debts will go up in smoke. But why does the US Fed wink such high-risk, usurious, sub-prime lending that endangers other economies? This is the logic: without loans, including bad ones, consumption spend would fall; and that would lead to an economic slowdown.

Says Business Week: "Consumer spend is closely watched by Wall Street as it constitutes 70 per cent of the GDP of the US." So, even bad loans are good as instant stimuli for the economy, like toxic drugs instantly hype up the health, no matter that, in the end, what massive damage toxics do to the body, excessive consumption loans do to the economy. But the tragedy is that it is monies saved by people in developing nations that are borrowed and lent as toxic consumer loans in the US.

The former US Fed chief, Mr Alan Greenspan, philosophised that borrowing to spend beyond current income is an index of a fully developed nation; in contrast, saving for a rainy day is the sign of a partly developed nation.

He was proud that "developed countries have vast financial networks that lend to consumers most often backed by collateral," enabling them "to spend beyond their current incomes" and enjoy their life. But the culture of spending beyond current incomes by borrowing seems special to Anglo-Saxon US, the UK, Canada and Australia, not to other equally developed nations such as Germany or France, Italy or Japan.

Again, the credit network of the US draws on the savings of the developing nations to finance or refinance consumer loans in the US. If Mr Greenspan's philosophy is extended, borrowing from developing nations by developed nations to make loans, including toxic loans, to its people for consumption spend is also an index of developed nations!

Toxic lending

The 'vast financial network' of the US, of which Mr Greenspan feels proud, has been, over the last decade, increasingly driven by extensive toxic lending. Result, the rest of the world is paying for the toxic effect of the 'vast financial network' of the US. So, when the sub-prime bomb exploded, it was the European Central Bank, not the US Fed, that issued a cheque for $500 billion to save the European banks that had huge investments in CDOs.

The Bank of England separately gave $20 billion to UK banks, while the Western central banks agreed to inject a further $100 billion in the banking system. In contrast, the US Fed made a moderate contribution of $20 billion - equal to just 3 per cent of the sub-prime penalty on the European central banks! More, a bank in Germany and a bank in England folded up, imposing a multi-billion-dollar revival cost on the two nations. This is where the sub-prime hit landed finally.

The US economic discourse of the past decade teaches that to manage a big crisis, postpone it by a massive dose of financial steroids, like sub-prime lending, even if it incubates into a bigger crisis and threatens to explode later. This was how the dotcom fallout of 2000 was postponed by toxic sub-prime mortgages.

And now the toxic effect of the latter and the fallout of the former have multiplied and emerged as a bigger crisis - the sub-prime scam. The attempt now is to postpone the cumulative effect of the dotcom crisis and sub-prime crisis through further and huge doses of financial steroids, like sub-prime credit cards and fiscal steroids like tax cuts. It is all in the hope that if consumption spend beyond current income is kept alive, the economy will move on, and some life vest will emerge in future.

But how long will this game of postponing one crisis by inviting a bigger one later in the hope something will emerge go on, and where will this game end? The next part deals with this trillion-dollar question. But, to end, if borrowing to spend is celebrated as a virtue and savings is dismissed as primitive, then toxic sub-prime missions in the US at the cost of primitive savers elsewhere are inevitable. So, the fault lies in the philosophy of life and in the mission of sub-prime lending, not in its mechanics or methods. The search now for what went wrong is more like the legendary blind men striving to comprehend the large and incomprehensible elephant through its disaggregated limbs. That is why the new dose of financial steroids through sub-prime credit cards.

Courtesy: www.thehindubusinessline.com, March 13, 2008