Understanding sub-prime crisis

Genesis of sub-prime crisis : Housing prices began coiling upwards in the U.S. in the early years of this decade and continued through mid-2006 with the borrowing and lending rates extremely low, which helped boost the demand for and supply of new and existing houses. Many banks offered home loans to borrowers with low or no credit background by requiring higher than normal repayment levels, thus creating what is now referred to as ‘sub-prime mortgages’. Understanding a few terms relating to sub-prime : A sub-prime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders (they lend to borrowers with good creditworthiness and financial soundness). Some sub-prime lenders are independent, but increasingly they are affiliates of mainstream lenders operating under different names. Sub-prime lenders seldom, if ever, identify themselves as such. The only clear giveaway is their prices, which are uniformly higher than those quoted by mainstream lenders. There are lenders who offer both prime and subprime loans. For borrowers who aren’t sure where they stand, dealing with a lender who offers both has a distinct advantage. They will try to qualify you for prime, and only if that fails will they drop you to sub prime. Lenders who are strictly sub prime might refer a prime borrower to an affiliated prime lender, but their financial interest dictates otherwise. Sub-prime lenders base their rates and fees on the same factors as prime lenders. For example, rates are higher, the lower the credit score and smaller the down-payment. However, the entire structure of rates and fees is higher at sub-prime lenders to cover the greater risk and higher costs of sub-prime lending. A higher percentage of sub-prime than of prime loans go into default. Sub-prime lending costs are also higher, because more applications are rejected and marketing costs are higher. Among sub-prime loans that don’t default, a higher percentage prepay early. Prepayment penalty clauses are often mandatory, and a high percentage of sub-prime loans have them. On the other hand, escrow of taxes and insurance, which is required in the prime market unless the borrower pays for a waiver, is often not required in the sub-prime market. The 2/28 ARM (Adjustable Rate Mortgage) : A very common mortgage in the sub-prime market is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and then reset to equal the value of a rate index at that time, plus a margin. Because the margins are high, the rate on most 2/28s will often rise sharply at the 2-year mark, even if market rates do not change during the period. For example, the rate is 8% for 2 years, but the index is currently 4% and the margin is 6%. If the index remains at 4% after 2 years, the loan rate will jump to 10%. Few borrowers with low credit scores take a 2/28 at a high rate and plan to rebuild their credit during the next 2 years. Prime borrower v. sub-prime borrower : The development of the sub-prime market has made mortgage finance available to a segment of the population that otherwise would have been kept out of the market considering their power to leverage their income. The add-on effect of subprime lending is that some borrowers who are eligible for mortgage finance from mainstream lenders end up in the sub-prime market. They are prime borrowers, but they pay sub-prime prices. This happens partly because of the difficulties some borrowers can have in determining whether or not they qualify in the mainstream market. Underwriting requirements can differ from one mainstream lender to another, so it is quite possible that a borrower with problems, who is not eligible at one lender, will be eligible at another. Among various reasons leading a prime borrower taking sub-prime loan are as below : 1. They are solicited by sub-prime lenders and go along with the deal pitched to them without ever contacting a mainstream lender. This is sometimes referred to as ‘steering’. 2. Sub-prime lenders market aggressively to home-owners who already have mortgages. A major pitch is the cash that borrowers can take out of their properties through a cash-out refinance. 3. Another common pitch is the lower payments possible on interest-only mortgages and option ARMs. The actual fall-out situation : Crisis situation began in mid-2004 after the interest rate hike by the Fed (U.S.). Due to the increased interest rates, the floating interest rate borrowers got impacted by the fact that the monthly instalment payment increased. The situation finally resulted in overleveraging the payment potential of the borrowers. The ultimate impact started to show by way of default in payment of loans and thus subprime crisis situation arose. The spill-over effect : The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares in Bear Stearns came under pressure in May 2007 because of the bank’s exposure to the U.S. subprime market. In June, Merrill Lynch seized and sold $ 800 millions of bonds used as collateral for loans made to Bear Stearns’ hedge funds that were used to bet on the sub-prime mortgage market. In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge funds hit by the defaulting sub-prime mortgages. Recent events in sub-prime : Given the dominance of U.S. financial markets in ther developed and developing economies, the sub-prime mortgage market crisis affected markets and institutions all over the globe. On July 27, 2007, worries about the sub-prime crisis hit global stock markets and the main Dow Jones stock index lost 4.2 per cent in five sessions, its worst weekly decline in five years. The fall continued in August. On August 3, 2007, the Dow Jones Index ended the session almost 2.1% lower. The same day, London’s main FTSE 100 stock index closed down 1.2% with French and German markets also declining. On August 9, French bank BNP Paribas suspended three investment funds worth USD 2 billion, citing problems in the U.S. sub-prime mortgage sector. The Dutch bank NIBC announced losses of USD 137 million from asset-backed securities in the first half of year 2007. The European Central Bank (ECB) pumped USD 500 billion into the European banking market to allay fears about a sub-prime credit crunch. SIVs : The impact of sub prime was such that it has also affected the SIVs too. SIVs are Structured Investment Vehicles which buy long-term debts including mortgage debts with higher interest rates and in turn issue short-term debts with low interest rates, in between making margin on the difference of interest rates. Due to sub-prime crisis, the SIVs were in panic, as they had to sell their debts in market at low prices, which could have resulted in to huge losses, but the situation was managed well by various banks by taking SIVs debt on their own balance sheet, thus they avoided the direct impact of sub prime over SIVs. The controlling factors : To control the situation, the Central Banks across the globe tried to maintain liquidity in the market and injected funds. In addition, they also tried to maintain the purchasing power by way of reducing the interest rates. To sum up, though the crisis seems over, the impact it may have on various financial institutions worldwide can’t be assessed considering the diverse portfolio under mortgage finance. Finally, there could be some things more in the ‘Pandora’s Box’. Disclaimers : The figures about sub-prime crisis are considered based on news circulated in various periodicals/journals The Article is drafted considering banks and mortgage lenders in general and not any specific bank or mortgage lender. Article by Mr. Abhishek Sharma ,a renowed Chartered Accountant