[b]Washington's political establishment is the prime cause of America's sub-prime crisis. The comprehensive responsibility for this colossal crisis belongs to the White House and US Congress. But the blame has been wrongly assigned to Wall Street and to Mr Alan Greenspan, the former chairman of the United States Federal Reserve Board.[/b]

Washington started the war in Iraq in 2003. It then chose the wrong method of funding. It has channelled over $500 billion of short-term borrowings into the war since 2003. This is more than eight times the $60 billion estimated prior to the start of the war. Washington was optimistic that the war would be very short and very cheap. It has been neither.

Washington's misjudgement has inflicted enormous costs. It first tripped the economy. It then ripped the mortgage industry. But America's commercial banks are liquid and solvent. There are no Northern Rocks. Northern Rock is a British mortgage bank that was devastated by mortgage defaults; it was nationalised in February 2008.

America's commercial banks are safe because Wall Street securitised the mortgages, especially the sub-prime mortgages, and invested in them. No one is thanking Wall Street for this protective role. But the calls for rigorous regulation and intrusive policing of Wall Street have grown louder. These have deflected public attention away from Washington's egregious misadventure.


Complementary competencies
Critics of Wall Street do not understand why investment banks are mired in the sub-prime crisis. Surely, investment banks do not lend to buyers of homes. Commercial banks do nearly all the lending to home buyers. Investment banks securitise these loans. Lending and securitising are complementary competencies.

If a commercial bank had $1,000 of deposits and then gave this $1,000 away as ten $100 loans to ten borrowers, it faces the risk that some borrowers may default. If some borrowers defaulted, the commercial bank and its depositors would be in trouble.

So, the commercial bank sells the ten loans as an unsorted bunch to an investment bank at, say, $1,020. The investment bank's core competence lies in selling the loans as ten securities, say, at $105 per security. The interest and principal (the periodic mortgage obligation) paid by the ten borrowers will then be paid to the holders of the ten securities.

Securitisation restores liquidity to the commercial bank. Moreover, the commercial bank and its depositors are not exposed to the risk of default by borrowers.

Sub-prime's attractions

America's consumer credit markets have shifted dramatically since the early 1980s. They have moved away from credit rationing towards risk-based pricing. No applicant is denied credit. Risky applicants are offered credit at higher prices intended to reflect the greater risk posed by these loans. Suppose the commercial bank knows that five of its ten borrowers are very unlikely to default. It applies risk-based pricing using a benchmark, say, the three-month US Treasury Bill (T-bill) rate. The bank lends to these 'prime' borrowers at 4 per cent over the annualised T-bill rate. The five loans to the prime borrowers are sold to the investment bank at, say, $540. The investment bank then creates five securities from the prime bunch and sells each at, say, $110.

The commercial bank applies risk-based pricing to the other five borrowers that are more likely to default. They are perhaps more vulnerable to economic downturns. So, it lends to these 'sub-prime' borrowers at T-bill rate plus 8 per cent. The five loans to the sub-prime borrowers are sold to the investment bank at, say, $480. The investment bank then creates five securities from the sub-prime bunch and sells each at, say, $100. The lower price reflects the higher risk.

Sub-prime securities are cheap at $100 apiece. And, sub-prime securities receive mortgage payments calculated with an annual interest of the T-bill rate plus 8 per cent. By contrast, prime securities are expensive at $110 apiece. Moreover, they receive mortgage payments calculated with an annual interest of merely the T-bill rate plus 4 per cent. Therefore, the return on prime securities is considerably lower than that on sub-prime securities. But prime securities are less risky. Investors with a poor appetite for risk choose prime securities.

By contrast, the return on sub-prime securities is considerably higher than that on prime securities. The adventurous with an appetite for high risk and higher returns choose sub-prime securities. So, sub-prime securities backed by loans to risky borrowers in the US found a huge market first in the US and then in Europe and Asia. This market included some investment banks.

Iraq blows America's fuse
The war in Iraq has been funded primarily by borrowings. Generous tax cuts since 2000 had made borrowing unavoidable. But Washington had no realistic timetable for the war. So, the US Treasury chose to issue short-term T-Bills that mature, say, every quarter. It may have borrowed long term by issuing, say, 10-year notes and 30-year bonds if there had been a realistic timetable.
The dependence on short-term borrowings affected short-term interest rates. The average three-month T-Bill rate in 2003 was 1.04 per cent. It rose to 1.41 per cent in 2004 and then more than doubled to 3.22 per cent in 2005. It rose further to 4.85 per cent in 2006 and stayed there until September 2007.

In defence of Greenspan

The US Federal Reserve under the leadership of Mr Greenspan till January 2006 responded correctly and swiftly to the inappropriate method of funding the war. It periodically raised the federal funds rate, the rate at which banks manage short-term liquidity. When the war began in March 2003, this rate was 1.25 per cent. It was a whopping 4.5 per cent when Mr Greenspan handed over charge in 2006 to Mr Ben Bernanke, his successor.

Mr Greenspan raised the federal funds rate on 14 occasions after the war began. Therefore, it would be patently wrong to claim that Mr Greenspan triggered a housing bubble by keeping interest rates low. Mr Bernanke too kept pace with the war's unfavourable consequences. The federal funds rate rose to 5.25 per cent after three more hikes in 2006.

Iraq flattens America

Short-term interest rates rose above the long-term interest rate in America. The average three-month T-bill rate was 1 per cent in 2003; the average 10-year T-bill rate was 4 percent. The average three-month T-bill rate rose to 4.85 per cent in 2006. But the average 10-year T-bill rate was merely 4.79 per cent in 2006.

Rising short-term rates and a long-term rate that was lower than the short-term rate meant that America could no longer fund long-term assets profitably. America was forced to defer long-term investments that usually create the steady, long-term jobs.

Who would pass up a short-term return of 4.85 per cent without any risk to fund a long-term asset that had a mere 4.79 per cent return but all the long-term risk? So, America's recession is a result of the war in Iraq. The mortgage crisis came thereafter.

Iraq crushes Americans

The war in Iraq then began crushing American homeowners with mortgage payments indexed to either the T-bill rate or the federal funds rate. Almost all sub-prime borrowers had adjustable rate mortgages. Their mortgage obligations rose when short-term interest rates rose. They struggled to make their mortgage payments.

Home prices began to fall when the economy began to stall. Wages too began to fall. Many sub-prime borrowers began to lose jobs when America began to postpone long-term investments.

But mortgage obligations continued to rise. Many borrowers chose to default. Who would honour a mortgage obligation of $100,000 when a home's resale value fell to, say, $50,000? Default is a rational choice in such circumstances.

However, America's commercial banks have not had to face the adverse consequences. Wall Street has borne most of the massive losses because it had chosen to invest in the sub-prime securities. It is unjust that it should bear any guilt at all. The blame for Wall Street's plight belongs to Washington