The U.S.

Sub-Prime Crisis :

A Brief Comparison with the Asian-Pacific Financial Crisis and

Possible Remedial Steps

(A Final Exam Paper Written for U21 Global, by Alwyn Lau)

A. The United States Sub-Prime Crisis

The sub-prime phenomenon represents a shift in the way that mortgages have been
traditionally funded. In the past, banks funded mortgage loans from the deposits
they received from their clients1. When coupled with a system of regulations, loan
viability evaluations, checks and balances, this minimized risks of defaulting loans,
bank-run inducing panic, etc2.

However, sub-prime financing began with a desire to cater to high-risk borrowers

with weak credit histories and weak documentation of income3 hence the label, ‘sub-
prime’. Banks processed the mortgage payments as mortgage-backed securities,
mortgage bonds or collateralized debt obligations (CDOs’) and subsequently sold
them to financial institutions worldwide. This also witnessed a rise in private sector
involvement in the mortgage financing market, which reaped huge profits by riding
on the demand for easy financing (the mortgage bond market was worth US$6
trillion as at November 20074).

The success of CDOs’ was spurred on by a long-term trend of rising housing prices
and loan incentives which encouraged borrowers to believe they would be able to
refinance at more favorable terms later5.

However, with the fall of house prices, mortgage lenders began calling in their loans.
This affected borrowers many of whom, being high-risk and of low-(re)payability
status in the first place, defaulted. As more defaults occurred and more foreclosures
were announced, mortgage lenders and the third-party investors who had bought the
credit-risk (via the CDOs’ and similar instruments) were also affected with significant
losses. The dispersion of credit risk and the widespread effect on financial institutions
in turn caused lenders to reduce lending activity or to make loans at higher interest
rates, which in turn reduced the availability of and access of fund by individuals and
corporations not originally involved in mortgage-backed securities, thereby creating a
credit crunch, a economy-wide and multi-sector disappearance of credit as a
spiraling result of falling confidence in one sector (in this case, the sub-prime
market)6.

B. The East Asian Financial Crisis

The East Asian financial crisis of 1997-8 developed along similar lines. As with the
sub-prime fiasco, it began with a frontier of new opportunities for profit i.e. the new
emerging Asian-Pacific markets. Massive expansion of credit occurred to fill the
demand for a wave of new investments which took the form of both actual
constructions and speculative activity7. The latter kind of investments eventually
grew as unbridled optimism and promises of even greater gains fueled more and
more lending, then over-lending, far stretching the bounds of a healthy risk market.
Also, many East Asian financiers were neither ordinary banks nor investment banks
but institutions with good political connections. With access to funds on low interests,
owners of these financial companies began lending out (on high interests) to
speculators who wanted to make a killing by betting on, say, the real-estate market8.
The liberalization of capital accounts to allow firms (including banks) to take on
short-term foreign debt and the virtual non-existence of foreign exchange hedging
created even more vulnerability9.

In mid-1997, some speculators went bust, some finance companies closed shop,
reducing confidence. Foreign lenders became more reluctant to lend. Local currencies
were floated and immediately devaluated, thereby aggravating the debts of many
local banks and finance companies, most of whom borrowed in foreign currencies,
usually dollars. Central Banks then tried to limit the currency’s decline by raising
interest rates, further stifling loans and economic growth10 – this is the parallel to US
financial institutions raising lending rates as a result of overall reduced confidence in
borrowers’ ability to repay. The combination of higher interest rates with falling
investor confidence and dodgy balance sheets contributed to many East Asian
economies entering a state of meltdown (apparently, only Hong Kong escaped
devaluation11).

C. Comparing Both Crises

There are many similarities between the two crises. They were both the result of
unchecked profit-seeking taking the form of high-risk lending (which focused on real-
estate prices); in both cases, greedy optimism blinded most to cautionary measures
(in the U.S. it was optimism in the housing market, in Asia it was buoyancy in Asia’s
emerging economies); in both cases, financial regulation and supervision were
slipshod; in both cases, the risks were extended across the financial community and,
when the bubble burst, even parties not initially involved were affected because the
entire lending/borrowing system was infected.

On the other hand, there are also differences.

First, the sub-prime crisis was limited to the U.S. national economy (although debate
continues as to whether other regions were impacted12, the general consensus now is
that they weren’t, or at least not significantly13) whereas the East-Asian crisis was
almost by definition a region-wide event.

Secondly, the East-Asian crisis was aggravated by the actions of financial and
currency speculators14 (it was also the time when the name of George Soros would
be one of infamy, especially among Malaysians and Thais15), which were non-existent
in the sub-prime situation.

Another key difference was that foreign investors played a major role in the East-
Asian crisis, whereas in the sub-prime crisis it was mainly limited to American
nationals. This suggests the culpability of non-Asian investors in the 1997 calamity
who did next to no evaluations of their own, and who stood to lose nothing as long
as their Asian ‘crony capitalists’ partners promised to pay them back. In a very sad
way, it was the non-wealthy of Asia who suffered the most from the actions of their
rich leaders and even richer foreign lenders (not to mention the currency
speculators16). In the sub-prime crisis, however, all parties suffered and in this sense
it may be right to say that the misery was shared all across instead of being
concentrated on the underprivileged many.

D. Tackling the Sub-Prime Crisis

Immediate efforts by the U.S. Federal Reserve to manage the crisis include
supporting market liquidity and using monetary policy (see Appendix 1 on the
relation between monetary policy and economic growth)17. The Federal Reserve has:

i. conducted open market operations (i.e. short-term loans to banks

collateralized by government securities) and Term Auction Facilities (TAFs’) to
ensure that banks have access to funds
ii. lowered interest rates for short-term loans

iii. announced term-repurchase agreements to enhance the ability of financial

institutions to sell mortgage-backed and other debts18

The hope is that short-term funds would stimulate the commercial paper market and
general economic activity. Funds and guarantees have also been provided to enable
JP Morgan Chase to purchase Bear Stearns (a large financial institution with heavy
mortgage-backed securities instruments that has plunged in value), in order to avoid
a potential ‘fire sale’ of nearly US$210 billion of Bear Stearns’ MBS and other assets,
further exacerbating the crisis19.

In addition, the Federal Reserve is also proposing the reduction of loan principal
amounts to address a concern that U.S. house-owners with negative equity (i.e.
homes worth less than the mortgage principal) will have a financial incentive to ‘walk
away’ from the property20.

In the 1997 Asia-Pacific crisis, the short-term imperative was to restore the
decimated funds of the Asian economies as means of propping up their financial
system and preventing further downwards-spiraling (via IMF funds or the use of
capital controls to prevent the outflow of foreign currency, as in Malaysia 21). This
appears to be the objectives of the Federal Reserve System i.e. to stop the defaults,
to defeat the credit crunch and get the monetary system on its feet again. The fiat
lowering of interest rates, whilst creating discomfort for lenders, would at least
encourage more lending in other areas of the economy (where, perhaps, repayment
risks are far lower).

Medium- and long-term solutions include:

i. Lenders assisting homeowners provide more favorable mortgage terms (via

loan modification or refinancing)22

ii. Credit rating agencies helping to evaluate and report on the risks of
investment instruments, to reexamine and improve the rating processes.
Large amounts of mortgage-backed debt have also been downgraded
iii. Regulators and legislators are taking action regarding lending practices,
bankruptcy protection, tax policies, affordable housing, credit counseling and
the licensing and qualification of lenders.

How effective are all the above in preventing a crisis of a similar nature?

Whilst ‘only time can tell’, we can nevertheless make a future-oriented assessment
by comparing the solutions proposed/implemented with how well they tackle the
causes of the crisis. If the sub-prime crisis was a result primarily of self-fueling
speculation and unregulated access to funds, then certainly options like a revamping
of the role of credit rating agencies and stern action by regulators and legislators go
straight to the heart of the matter. What’s disturbing is how and why the credit rating
agencies provided triple-A (i.e. ‘very safe’) ratings for mortgage-backed securities in
the first place.23

Perhaps more fundamentally, the Federal Reserve must be more cognizant of the
impact on under-priced (and under-reported) risks to the banks. This refocuses
efforts more prevention rather than cure and gets the Central Bank deep into the
nature of risk-assets held by banks (whether on or off their balance sheets) allowing
them to better manage the supply of money and credit, instead of merely tackling
short-term symptoms of inflation and credit crunches24.
E. Lasting Effects of the Sub-Prime Crisis

The sub-prime crisis affects the rest of the world the way a major spender in any
economy (in this case, the world’s economy) impacts all other players. Low spending
in the U.S. causes slow demand and low expansion in American investments, both
locally and abroad. This eventually hits world markets dependent on American
investment and even leads to increase in world commodity prices like that of gold,
wheat, grain, oil and, of late, rice. The dropping dollar and consequently the
appreciation of foreign currencies, reduce the competitiveness of other countries’
exports which in turn ricochets into their respective economies25.

In East Asia especially the central banks hold huge foreign currency reserves mostly
in dollars. A weaker dollar will reduce the value of these reserves, and erode their
“protective buffer” against potential financial panics and a prolonged recession. More
than 20% of China’s exports go to the US, and about 54% to the high-income
economies; the decreased purchasing power of the dollar and the global
slowdown might take their toll26.

India was notably affected because foreign (mainly American) investors began selling
off their investments in Indian equity-based companies to cover their losses 27.
Nevertheless, because the mortgage market in India and other East-Asian countries
are nowhere as developed as those in the U.S. and Indian banks do not as easily
embrace structured and innovative investment assets as do their American
counterparts28. Indian banks must also comply with statutory liquid ratios (SLRs’),
contra many other Asian banks, let alone the U.S. banks. The SLRs’ allow
government-sponsored programs to access those funds at below-market interest
rates. India's central bank also requires banks to put aside 40% of their advances for
so-called "priority sectors" like agriculture and small business, where the returns are
low and many banks face bad debts29.

Conclusion
The sub-prime crisis may be viewed as a result both of unchecked greed and
speculation which were fueled by the possibilities presented by non-conventional loan
mechanisms and instruments.

Whilst it appears likely that the present crisis will abate eventually and at least the
worst is over30, with continuing financial innovation and poor memories of disasters
by those responsible for regulating rogue financiers, there is every possibility a crisis
provoked by heavy speculation on light fundamentals will occur in the near future.
Appendix 1: Monetary Variables and Economic Growth

The banking and financial sectors of a country influence the creation and growth of
the ‘real’ economy via the manipulation of interest rates, its handling of the
exchange rate, its efforts at price stability and the printing of money.

A Central Bank’s base rate (the rate of lending to other local banks) impacts housing
prices, disposable income of mortgage payers, consumer demand for credit, business
investments and consumer and business confidence which in turn may either
encourage slumps or peaks in the economy31. An interest rate represents the cost of
financing and, applying conventional economics, when the price of anything falls,
demand for said item rises. In this case, when interest rate falls, the demand for
money rises leading to more investments and so on.

Likewise, a country’s exchange rates (the cost of purchasing one’s domestic

currency), if overly high, can out-price its exports vis-à-vis its imports (because it
becomes more expensive for foreigners to buy our money and hence our goods),
affecting local producers (albeit delighting some of its consumers). However,
depreciation of the currency may raise the value of the debts valued in a foreign
currency. Similarly, there is evidence suggesting an indirect relationship between
inflation and long-term economic growth32, hence the desire of Central Banks to
stabilize prices33.

In summary, using the terminology of macroeconomics, monetary policy can be used

to control aggregate demand and supply. A ‘loose’ policy unleashes borrowing and
spending (though not without costs, as the sub-prime crisis proves) whereas a ‘tight’
one seeks to reign in runaway prices and failing loans.
End Notes
1
The US Sub-Prime crisis in graphics, BBC, 21 Nov 2007, viewed 17 May 2008, http://news.bbc.co.uk/2/hi/business/7073131.stm

2
Krugman, P. Partying Like Its 1929, 21 March 2008, The New York Times, viewed 17 May 2008,
http://www.nytimes.com/2008/03/21/opinion/21krugman.html?_r=1&oref=slogin
3
BBC, US Sub-Prime Crisis

4
BBC, US Sub-Prime Crisis

5
Sub-prime Mortgage Crisis, Wikipedia, viewed 17 March 2008 http://en.wikipedia.org/wiki/Sub-prime_mortgage_crisis

6
Wikipedia, Sub-prime Mortgage Crisis

7
Krugman, P. The Return of Depression Economics, Penguin Books, 1999, p.86.

8
Krugman, P. The Return of Depression Economics, p.88-89.

9
Reinert, K.A. Windows on the World Economy: An Introduction to International Economics, Thomson South-Western, 2005, p.271-2

10
Krugman, P. The Return of Depression Economics, p.94-95.

11
Reinert, K.A. Windows on the World Economy: An Introduction to International Economics, p.270.

12
The Economist, Lessons from the Credit Crunch

13
Citi Says Sub-prime Impact Limited in Asia, 31 Oct 2007, Reuters, viewed 18 May 2008
http://uk.reuters.com/article/ousiv/idUKBOM11787820071031
14
15
Krugman, P. The Return of Depression Economics, p.99.

16
Krugman, P. The Return of Depression Economics, p.89.

17
Speech by Federal Reserve Chairman, Ben S. Bernanke at the Women in Housing and Finance and Exchequer Club Joint Luncheon,
Washington, D.C.,10 Jan 2008, viewed 17 March 2008, http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm

18
Sub-prime Mortgage Crisis, Wikipedia

19
After Bear Staerns, Others Could be at Risk, 14 Mar 2008, MSNBC, viewed 17 May 2008, http://www.msnbc.msn.com/id/23638138/

20
Elphinstone, J.W. Housing Market Spirals, No End in Sight, 6 Mar 2008, Yahoo! Finance News, viewed 17 May 2008,
http://biz.yahoo.com/ap/080306/housing_woes.html
21
Malaysia’s Capital Controls Reasonable, 25 Oct 1999, World Banker, Asian Economic News, viewed 17 May 2008,
http://findarticles.com/p/articles/mi_m0WDP/is_1999_Oct_25/ai_57162829
22
Knox, N. & Kirchhoff, Criticism Rains Down on Mortgage Industry, 23 Oct 2008, USA Today, viewed 17 May 2008
http://www.usatoday.com/money/economy/housing/2007-10-23-mortgages-refinance_N.htm
23
Moore, E. Rating the Credibility of Credit Agencies, 17 Nov 2007, viewed 17 May 2008 http://uk.biz.yahoo.com/17112007/399/rating-
credibility-credit-agencies.html
24
The Economist, Lessons from the Credit Crunch

25
Chng, J. The Restructuring of Asian Market Amid Sub Prime Crisis, Press Exposure, viewed 17 May 2008
http://pressexposure.com/The_Restructuring_of_Asian_Market_Amid_Sub_Prime_Crisis-15244.html
26
Bocchi, A.M. Will East Asia Suffer the US Slowdown? 27 Feb 2008, East Asia & Pacific on the Rise, viewed 17 May 2008,
http://eapblog.worldbank.org/content/will-east-asia-suffer-the-us-slowdown
27
Mehta, V.H. 10 Feb 2008, The Sub-prime Crisis and Implications for India, The Financial Express, viewed 17 May 2008,
http://www.financialexpress.com/news/The-sub-prime-crisis-and-implications-for-India/271436/2
28
Sub prime crisis to have limited effect on India say analysts,7 Oct 2007, Domain-B.Com, viewed 17 May 2008 http://www.domain-
b.com/economy/general/2007/20071006_analysts.htm

29
How Indian Banks Cope with Unwanted Baggage in the Global Pecking Order, 10 Jan 2008, India Knowledge Wharton, viewed 17
May 2008,
http://knowledge.wharton.upenn.edu/india/articlepdf/4251.pdf?CFID=57774025&CFTOKEN=76965073&jsessionid=9a306cf16a564a31
1fa3
30
Desmond, M. Lehman Chief: Sub-prime's End--Near; Pain--Not Over, 16 Apr 2008, Forbes, viewed 17 May 2008
http://www.forbes.com/facesinthenews/2008/04/16/rishard-fuld-lehman-markets-face-cx_md_0415autofacescan03.html
31
Macroeconomics / International Economy: Monetary Policy, Tutor2u.net, viewed 17 May 2008, http://tutor2u.net/economics/revision-
notes/as-macro-monetary-policy.html
32
Papademos, L. The Contribution of Monetary Policy to Economic Growth, Speech Delivered at 31st Economic Conference (Vienna), 12
June 2003, European Central Bank, viewed 17 May 2008 http://www.ecb.eu/press/key/date/2003/html/sp030612_3.en.html#ftn.fn10
33
Towards this end, The Economist proposes extending the definition of inflation to include property and shares. See Lessons from the
Credit Crunch, 18 Oct 2007, The Economist, viewed 17 May 2008,
http://www.economist.com/opinion/displaystory.cfm?story_id=9988758