Subprime Mortgage Crisis

INTERNATIONAL TRADE AND FINANCE (HBI451)

Explain the Background of the Sub-prime Mortgage Crisis Problem. How is the crisis likely to affect the International debt and Equity Markets?

Prepared for: Julie Gerstman Prepared by: Mohammad Parvez Naim Student ID : 6565700 Submitted on: 4th Nov 2008

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Table of Content

1. Introduction…………………………………………………………………….2 2. Sub Prime Mortgage Crisis………………………………………………..3

2.1 What the sub prime mortgage is.............................................................3 2.2 Background of Subprime mortgage crisis…………………………………5 2.3 Factors responsible for Subprime crisis…………………………………...8

3. Impact of Subprime Mortgage crisis…………………………………….9 3.1 Lack of Liquidity………………………………………………………………9 3.2 Credit crunch…………………………………………………………………11 3.3 Share market down………………………………………………………….13

4. Effect on the International Debt and equity market…………………..13

5. Conclusion……………………………………………………………………15

5. References..........................................................................................…...16

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Introduction The Intention of this assignment is to understand the currently going major economic issue “Sub-prime Mortgage crisis problem” which was started in 2006 in the US. This crisis has now become global issue as it has affected major economies of the world and it is continuously growing. This Crisis was started with the US housing sector’s Boom and bust which had thrown US economy in to recession. In 2005, The US housing sector was on boom as the value of the houses has gone up to 140% due to large demand of the houses. The financial institution started providing loan to the Sub prime candidates who are not eligible to applying for Conventional loan. Overbuilding of the houses during the boom period eventually leads to decline house price. Due to which many homeowners and sub prime loan borrowers become default and Bank started foreclosure activity which leads to more downfall in housing price. Now, there were more houses and fewer buyers which create illiquidity in to the housing sector. Finally it landed banks in to the financial crunch. This report has been prepared to understand the major causes of this crisis and its impact on the International debt and equity market.

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1 Sub Prime Mortgage Crisis

1.1 What the “Sub Prime mortgage” is?

It is a kind of mortgage that financial institutions provide to the borrowers who have lower credit rating (often below 600) or who do not have credit history. The borrowers with poor credit history are not eligible to have conventional mortgage loan so, the financial institution provide them sub prime mortgage loan and charge them with higher interest rate as compared to conventional loan in order to compensate themselves for bearing higher risk.

Figure 1: Premium Charged on Sub-prime Mortgage Loan

Note: sub-prime premium is the difference between prime and sub-prime rates. Source: Chomsiseng S. & Pennington, A., “The Evolution of the Sub-prime Mortgage Market”, Federal Reserve Bank of St. Louis Review , January/February 2006

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There are several different kinds of subprime mortgage structures available. The most common is the adjustable rate mortgage (ARM), which initially charges a fixed interest rate, and then converts to a floating rate based on an index such as LIBOR, plus a margin. The better known types of ARMs include 3/27 and 2/28 ARMs. There are several terms and condition which are hidden in the agreement of Subprime Mortgage loan of which a borrower is not aware off. In fact some people calls it NINJA loans which means granting loan to people with no Job, no Income and with no Assets.

[ref:

http://www.investopedia.com/ask/answers/07/subprime-

mortgage.asp]

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1.2 Background Of Sub Prime Mortgage Crisis

What Leads to US housing Bubble (Retrieve from Wikipedia.com) The Subprime Mortgage Crisis threatens to throw the U.S. economy into a recession. The Sub Prime mortgage crisis is an ongoing financial crisis which is characterized by the contracted liquidity in global credit market. This crisis had become more apparent in year 2007 and 2008. The Subprime Mortgage crisis was started approximately in 2005-2006 began with the bursting of the United States housing bubble and high default interest rate on

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subprime loan and on ARM. What exactly happens is that in 2005-2006, at the height of the US property boom, when lenders started adopting creative methods to make home ownership more accessible for a population demographic which was previously unable to own their own home. The lending industry offered very flexible products like easy initial terms, no documents, honeymoon period etc in order to make monthly repayments affordable for these credit impaired clients and as a result:



Low start, honeymoon period was introduced with very low interest rate

which is as low as 1% or 2%. It becomes easy to make repayments for borrowers having lower income which is going to further fuelling the US property boom. However this low interest rate was just under honeymoon period which was reset to standard variable rate of about 7%. This Rollover made many subprime borrowers incapable of repaying.  Unscrupulous brokers and some lenders take the undue advantage of relaxation of credit policies to sign up clients who are unable to make necessary payments. These clients sign high income declaration which later called NINJA loans. Financial institution paid commission to the broker for every single NINJA loan.

The Subprime loans (NINJA loan) become very popular in the US which is evident by the fact that more than 7 million property owner of the US took out these types of loan. The whole new generation of new real estate investors caught up in this sub prime lending market.

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The crunch time come for many of the American investors when the validity of the honeymoon low interest period expires and the interest rate reset to standard variable rate which make many borrowers incapable for repayment. As the initial term expired the default and foreclosure activity increased dramatically in the US. During 2007, nearly 1.3 billion housing properties were subjected to foreclosure.

To handle the situation some finance experts packaged these loans with the US investment bank and sold them as AAA rated security to Institutions and lenders around the world with the promise of high net return through the process of securitization. But the number of default continues to grow in the US market which finally bring the value of the property down and also created illiquidity in the Credit market. The Institutions finally lost their money invested in these securities. All this finally leads to global financial crisis.

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Major Banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008. 1) [ref: http://www.propertyupdate.com.au/articles/304/1/The-US-sub-prime-crisis---Whatis-it-and-what-does-it-mean-for-Australia/Page1.html] 2) [ref: http://www.economywatch.com/us-subprime/crisis.html] 3)[ref:http://www.bloomberg.com/apps/news? pid=20601087&sid=atGti_UmcPnM&refer=home]

1.3 Factors responsible for Sub Prime Mortgage crisis  Unfair lending of Loan  Betting on collateral rather than borrower  Overbuilding of Houses during the boom period  Liquidity in the Housing market  Poor Anticipation of borrowers and lenders  High personal and corporate debt level

2 Impact of Sub Prime Mortgage Crisis 9

2.1 Lack of liquidity: Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline. Easy credit with the assumption that housing price would continue to appreciate had forced many subprime borrowers to obtain Adjustable Rate mortgage which they could not bear after the expiry of the initial terms. The increasing construction of the houses and fewer buyers create a housing glut. As a result, U.S has recorded nearly a four million unsold existing homes were for sale, including nearly 2.9 million that were vacant. More houses and less buyers create illiquidity in the housing market and real estate prices began to fall in many part of the US due to which refinancing become more difficult and the subprime mortgage borrowers were unable to refinance and began to default on loans as their loans reset to higher interest rates and payment amounts. This increases number of default and foreclosure rate provide the additional supply of inventory house. This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure.

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The house plunge leads to more delinquencies and foreclosures generating a vicious cycle The Value of the AAA rated Mortgage back security which was purchased by the Institutions and lenders also become less and they had suffered a huge loss in this. The Investors loose their confidence and they are not willing to purchase any Mortgage backed securities anymore. Finally it leads to Lack of Liquidity into the credit market because banks are not able to make payments of policies on maturity date due to lack of funds. This inability of Bankers of lack of funds in the credit market slowly leads global financial crisis. Moreover, the size of the crisis can not be determined with any degree of certainty. The uncertainty has eroded market confidence raised the volatility of financial markets. [ref:http://www.businessweek.com/magazine/content/08_06/b407004076751 6.htm?chan=rss_topStories_ssi_5 and http://biz.yahoo.com/cnnm/080513/051208_q12008_home_prices.html]

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2.2 Credit crunch: The U.S sub-prime crisis has resulted in multi billion $ loss to international banks like Citibank etc and investors world wide who have invested in the MBS. There is a severe credit crunch in the sub-prime segment of the mortgage market. Till now 30 sub-prime lenders is out of the market. New Century was the last one to get out of the business who is known to be the second largest subprime lender. Many more lenders are losing massively on their sub-prime operations. Investor fears have been exacerbated by uncertainty about the full scale of losses and distribution associated with sub-prime exposures. The Housing price going down continuously and the number of default and foreclosure are increasing are the reason for investors fear. The lending standards have been sharply tightened by many lenders and regulation around the world. Economists at Goldman Sachs in New York said in a report this week that the tightening of subprime credit could cut annual demand for new homes by 200,000 units, or about a fifth of new-home sales last year. Australian has also affected from the U.S sub-prime mortgage crisis. The issuance of residential mortgage backed securities (RMBS) as an important long-term funding source has reduced significantly. Since July 2007, new issuance only accounted for less than AU$5 billions compared with AU$25 billions in the first half of 2007.

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Source: RBA, Sept 2008, page no. 30

Asset-backed commercial paper market (ABCP), which provides securitized short-term funding for vehicles holding a variety of financial assets, has also shrunk with falling outstanding. As at July 2008, the outstanding value of offshore ABCP issued by the Australian entities was just over $ 7 billion, around 80% lower than its peak in May 2007. [http://www.rba.gov.au/PublicationsAndResearch/FinancialStabilityReview/Sep2008/Pdf/fin ancial_stability_review_0908.pdf]

Finally global credit crunch has squeezed economic growth.

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2.3 Stock market down: The US sub-prime crisis has triggered the sharp decline of stock market worldwide. Trillions of dollars have been wiped off global share markets as investors panic in the face of an economic slowdown. The Investors are not willing to invest in Bond, Treasury note etc. And they started withdrawing their investments due to which stock market goes down and interest rate gone up. Report publishes on February 2008 by the Bank of America estimated a global loss of US$ 7.7 trillion in the stock market since October 2007. [ref: http://www.news.com.au/business/story/0,23636,23217631-462,00.html]

3 Affect on the International Debt and equity market This Crisis will have some negative affects on the international debt and equity market. The U.S financial crisis, which has sent tremors around the world, is likely to slow down foreign institutional investors' investment in India's equity markets. The risk of economic fallout from the US subprime housing crisis has decreased following the recent 0.5 percent cut in the US Federal Funds rates. Although Investment banks have aggressively reduced their underwriting of new debt issues to cover their own anticipated and unanticipated funding needs. Investors mainly banks, institutions and high-net-worth individuals who have long positions in the global markets, will incur losses on their exposure to the collateralized debt obligations, hedge funds and leveraged-buyout activities. While banks from the Middle East region face little or no risk from the subprime crisis, some private equity firms operating in this part of the world will be affected. Private equity firms operating in Middle East region are less dependent on

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leverage finance compared with those in the West. The debt markets worldwide and in the Middle East region will be affected more than the stock markets. The Sub prime mortgage in the U.S and Europe has choked off funding for private equity teams, Bloomberg reports the funding squeeze resulted in 63% drop in global buyout in the second half 2007. Global equities are in a bear market. Equity markets continued to rise until mid-May. After that, though, they tumbled back, so that the MSCI world index is now below that March low. Indeed, global equities are now down 12% year to date and around 20% from the high of October 2007. The global index is now at its lowest level since October 2006. The equity bear market is confirmed. To date, banks and financial houses have written off more than $425 billion of their assets. The cost of capital, as expressed in corporate bond yields and mortgage rates, has moved higher. Corporate earnings are now in negative territory in the US and Europe. Above all, real GDP figures are heading south everywhere, while inflation rates are heading north. That is a deadly combination. From here, the credit cycle is moving from big percentage losses incurred in sub-prime mortgage debt to the more typical small percentage losses in the general mortgage, consumer and corporate sectors that are incurred in an economic recession. Liquidity contraction will ricochet through more pools of debt, causing leverage to contract for the real economy. That will hit financial market prices further. The global economy is heading into a recession, as the economic data are beginning to reveal. This will be expressed in falling profit margins and negative earnings growth. That's bad news for equities.

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Assets are yet to be hit in the credit crisis and, as leverage continues to fall out of play, liquidity will keep on drying up. Equity prices are bound to fall still further too. To Conclude, There will be some degree of negative affect on the International debt and equity market which may differ from region to region. Like the Subprime mortgage crisis is likely to have only a limited effect on the equity and debt market of Middle East region due to their support of huge investments in infrastructure and a confident private sector positioning itself for growth and expansion. The impact of the crisis will be more visible if the world economic growth will further decline. [ref: https://www.zawya.com/story.cfm/sidDS240907_dsart14] [ref: Library Database]

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Refrences:

1) What is Subprime Mortgage? Viewed on 15th oct,2008 [ref:

http://www.investopedia.com/ask/answers/07/subprime-mortgage.asp]

2) The US sub-prime crisis - What is it and what does it mean for Australia? Viewed on 18 Oct 2008 [ref: http://www.propertyupdate.com.au/articles/304/1/The-US-sub-prime-crisis--What-is-it-and-what-does-it-mean-for-Australia/Page1.html] 3) US Subprime Mortgage crisis, viewed on 18 Oct 2008 [ref: http://www.economywatch.com/us-subprime/crisis.html] 4)[ref:http://www.bloomberg.com/apps/news? pid=20601087&sid=atGti_UmcPnM&refer=home]

5) Housing Meltdown, viewed on 27th oct 2008 [ref:http://www.businessweek.com/magazine/content/08_06/b4070040767516.ht m?chan=rss_topStories_ssi_5

6) http://biz.yahoo.com/cnnm/080513/051208_q12008_home_prices.html

7) Reserve bank of Australia, Financial stablity report, viewed on 28th Oct08 [http://www.rba.gov.au/PublicationsAndResearch/FinancialStabilityReview/Sep20 08/Pdf/financial_stability_review_0908.pdf]

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8)[ref:http://www.news.com.au/business/story/0,23636,23217631462,00.html

9) What the US Subprime crisis means to Middle East, Viewed on 31stOct 08 [ref: https://www.zawya.com/story.cfm/sidDS240907_dsart14]

10) Library Database, viewed on 2nd Nov 2008

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