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The sub-prime debacle--should we worry? The US sub-prime mortgage debacle has already incurred losses of around $100bn but the fallout is far from over. Has the contagion spread to Africa?

The latest jitters emanating from the collapse of the US sub-prime mortgage market, have raised fears about a generalised credit squeeze (i.e. the amount of money circulating in the banking system), thereby hurting companies and consumers.

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Axel Weber, president of the German Bundesbank, says: "What we are seeing is basically what we see underlying all banking crises." The International Monetary Fund (IMF) comments:

"Losses emanating from the US housing slump have hit the balance sheets of banks and hedge funds and created the worst liquidity squeeze in a decade. The principal risk is that market turmoil will damage the real economy through declining asset prices, tightening credit crunch with a re-pricing of risk and weaker confidence."

Sub-prime mortgages do not conform to the 'triple A' mortgage lending patterns and thus have a lower expected probability of full repayment. They comprise mortgages to borrowers with impaired credit histories.

At end 2006, sub-prime loans comprised 15% ($1.5 trillion) of outstanding US mortgages. Delinquencies (defaults) on these riskier loans have sky-rocked as interest repayments rose over the past two years. The Federal Reserve puts sub-prime losses at $100bn which, though below the early 1990s Savings/Loans crises that resulted in total losses of approximately $150bn--is much higher as a share of US banking sector assets.

Why are sub-prime woes having such devastating effects on capital markets?

The situation has been exacerbated because those mortgages were bundled [i.e., repackaged] into securities called Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs)--which are derivatives backed by pools of credits (including less risky loans).

These complex debt instruments were then sold to banks and hedge funds around the world as 'top-quality' investment grade paper--with the full blessings of major rating agencies such as Standards & Poor's (S & P) and Moody's.

In fact, the CDOs have now proved to be 'junk' securities and are practically worthless due to the surge in sub-prime home-loan defaults. S & P reckons that investment-banking revenues could plunge 50% in the second-half of 2007, hit by bad debts affecting Wall Street finest names such as Bear Stearns, Goldman Sachs, Lehman Brothers and Morgan Stanley.

Markets remain, as yet, unsure which banks carry the most risky assets. A quote from Donald Rumsfeld, former US Defence Secretary, best describes current investor mood as: "We know, there are known knowns ... But there are also unknown unknowns--the ones we don't know we don't know."

Apparently, S & P and Moody's had failed to price debt accurately--perhaps they were eager to secure further securitisation business (the repackaging of secondhand loans).

President Sarkozy of France spotted "very low levels of risk evaluation", and said governments must subject "to a careful examination" the exact role-played by ratings agencies in assessing corporate risks.

The crisis engulfed not only stock/bond markets but also commodities. It prompted the world's major central banks (as the lender of last resort) to provide liquidity to the markets, thus preventing widespread financial panic. The European Central Bank injected over 250bn euros until early September.

Prolonged spells of credit crunch will, however, damage the global economy, hitting exports and foreign investment prospects in Africa. Those emerging economies (notably South Africa and Turkey), which have a higher reliance on external financing could be vulnerable to market volatility with investors now expecting additional premiums for lending to non-OECD countries.

In sum, at the root of the US mortgage debacle were greedy financiers, lax regulations and incompetence of ratings agencies to spot the dangers of sub-prime securities. In some cases, mortgage lenders approved so-called 'Ninja' loans to families with no real collateral.

Could such fiascos occur in Africa? The answer is probably 'no' since consumer lending practices in the developing world are much tougher. Besides, 'mass' retail banking services (including mortgage finance) as yet to take-off across Africa--where most banks participate in secured corporate finance and international trade.

What can regulators do to avoid similar crisis in the future? Banks should ensure that lending is based on borrower's credit score, debt service-to-income and mortgage loan-to-value ratios. Consumers must be also be protected against imprudent activities of some micro-lenders, who charge punitive interest rates.

Ironically, much of the financial turmoil over the past five-six years has emanated from America when you consider the impact of the dot.com bust, 9/11, corporate scandals, Iraq's catastrophic 2003 invasion and now the sub-prime housing saga!
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Title Annotation:OPINION
Comment:The sub-prime debacle--should we worry? The US sub-prime mortgage debacle has already incurred losses of around $100bn but the fallout is far from over.
Author:Siddiqi, Moin
Publication:African Business
Geographic Code:60AFR
Date:Oct 1, 2007
Words:726
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