The US sub-prime mortgage problem

inSight

06 Sep 2007

The US sub-prime mortgage problem

The US sub-prime mortgage problem may not have systemic implications for Hong Kong's banking sector, but banks and other market participants should watch out for risks and uncertainties.

I mentioned in a Viewpoint article earlier that the distribution of risks in the financial system through securitisation poses risks to monetary and financial stability because it becomes less clear where the risks really lie, who is assuming them, whether they are being prudently managed and what happens if some risks deteriorate more than expected. The recent events linked to the US sub-prime mortgage problem clearly demonstrated this. Readers may have noticed from news reports that a number of overseas financial institutions and the investment funds they manage have incurred substantial losses as a result of their exposures in the US sub-prime mortgage market. I would not be surprised if we continue to hear this sort of news, at least in the near future. So the natural question is, how about banks in Hong Kong?

Banks in Hong Kong have a long history of investing in securities. But it is only in recent years that some have begun to invest in more complex instruments such as credit derivatives, primarily for yield enhancement. Although these banks generally felt that they would be more or less insulated from credit risk in the US sub-prime mortgage market simply by restricting their investments to investment-grade instruments, this view has now proved to be too sanguine, as recent events in the US market led to a significant drop in the market values of even the A-rated US sub-prime mortgage-backed securities. Thanks in part to comparatively slower development of the credit derivatives market in Hong Kong, the risk arising from exposures to securities and credit derivatives with a sub-prime component is closely monitored by banks in Hong Kong.

Information submitted by locally incorporated banks to the HKMA indicates that their aggregate exposures to the US sub-prime mortgage market do not have systemic implications for our banking sector. While this is a relief to many, we should not be too complacent. As I have pointed out before, the difficulties for the regulators in maintaining market surveillance on monetary and financial stability as risk transfer among market participants becomes more efficient is definitely an issue that deserves closer examination. I can also think of two other lessons that we may learn from the incident.

The first is about the ability of market participants to understand what they are buying into. The experiences of the troubled financial institutions underscore not only the extent of the US sub-prime mortgage problem but also the risks that banks have taken on, perhaps inadvertently, in an effort to boost revenue in an environment of lacklustre loan demand, low interest rates, excess liquidity and unprecedentedly narrow credit spreads. It is a common concern among banking supervisors around the world that the boards of directors and senior managements of banks may not possess sufficient expertise in understanding the market risks they are getting into when making sizeable investments in exotic instruments such as CDOs. There is a strong tendency for banks to rely heavily on the advice of a few senior executives and risk-management personnel to manage the risks, which are often hidden beneath layers of complex structure. What is also not commonly observed by banks is the need for robust stress testing, which would otherwise give a clearer indication of the potential impact such investments could have on the bank's financial position in the event of significant and prolonged adverse changes in asset quality or market liquidity. Where these due-diligence measures have not been meticulously established and vigorously enforced, any bank contemplating investments in exotic credit and debt instruments should think twice.

The second issue is related to the first. Good credit ratings should not be taken as "guarantees" that a particular investment is risk free. One of the most commonly cited justifications for a bank to take on an exotic investment is that the instrument concerned has obtained an investment-grade rating. Although credit ratings do provide some indications of the chance of default, they are merely opinions of the rating agencies based on in-house rating models and according to certain assumptions and historical data. Investors normally have no way of obtaining, let alone understanding or questioning, those assumptions and data. While history often repeats itself, market distortions and corrections do not always manifest themselves in the same way. Recent events have shown that the speed with which credit rating agencies react to changes in market environment leaves a lot of room for debate, and downgrades by them can have a pro-cyclical effect on market price, making life more difficult for those shouldering the risks. Banks should therefore always do their homework to ensure they understand the underlying assets relating to the instruments they are buying, the markets in which the underlying assets operate, and the rating given by the rating agencies.

While some in the market are hoping for more government intervention in the form of interest-rate cuts or government-sponsored entities buying more mortgage-backed securities to keep the market going, others are projecting that the US mortgage credit quality will weaken further in the second half of 2007 or even well into 2008 as more sub-prime adjustable-rate mortgages reset to higher floating rates. The outcome of the US sub-prime mortgage problem and its effect on the global economy are still unpredictable, and market participants should watch developments closely.

 

Joseph Yam
6 September 2007

 

Click here for previous articles in this column.

 

Document in Word format

Latest inSight
Last revision date : 06 September 2007