US sub prime mortgage market crash and its aftermath
Saturday, 8 December 2007
Shireen Scheik Mainuddin
ONE of the advantages of Dhaka's regulated Foreign Exchange Market is that international shake-ups in the financial world pass over without any effect. It explains why the 07 crisis has received little attention since our financial sector has not yet ventured into the largely unregulated area of commercial paper and securities.
Having recorded the events of the autumn of this year as I watched them unfold in the hard-hit London market, only now does the extent of the devastation become apparent. As a keen observer, it is vital to pass on the ripple effect that the crisis has created in the world-wide economy and the lessons to be learnt from the episode.
The US housing industry was being encouraged by selling loans to less than credit worthy borrowers who were termed "sub prime". The risks relating to the inability of homeowners to make their mortgage payments were distributed, through innovative securitization and globalization, by the lenders to global banks who resold the debt to institutional buyers all over the developed world. One of the features of these home loans was that interest rates were adjustable and would move up or down with the markets. In 2006 there was a rise in U.S interest rates bringing with it an increase in monthly payments on the adjustable rate mortgages. At the same time property values declined and many home owners were unable or unwilling to meet financial commitments. In turn, primary lenders were left without the means to recoup their losses as a result of which the securitized paper lost its value, with more sales than the markets could handle. The sub prime paper was owned, sold and traded by the leading names in the world financial markets and a classic domino effect followed as institution after institution fell victim to the virus. The effects of the meltdown spread beyond the U.S housing markets, disrupting global financial markets as investors, largely deregulated foreign and domestic hedge funds, were forced to re-evaluate the risks they were taking.
The ongoing problems are reported under various names ,the sub prime mortgage crisis, the bubble burst in housing prices, the meltdown in SIV but whatever the name the underlying issue remains the same.
The size of the US sub prime mortgage market is estimated at $1.3 trillion as of March 2007. An extensive review of various reports on the subject indicates that approximately 16 per cent of sub prime loans on adjustable interest rates were 90-days into default or in foreclosure proceedings as of October 2007. A total of nearly 447,000 U.S. homes were targeted by some sort of foreclosure activity from July to September 2007. The estimated value of sub prime adjustable-rate mortgages resetting at higher interest rates is $500 billion for 2008. The availability of these figures brings to mind the inevitable question: Given the large amount lent to a high risk group why hadn't the simple question 'What will happen if house prices go down and interest rates go up' been tested? Given the additional fact that testing is mandatory under Basel 11, which all banks are due to implement by 08, this is even more surprising.
The aftermath till date has been three fold:
1. The most immediate has been bankruptcy and decline in share prices of the institutions involved in the trade. The first to be hit were the mortgage banks with direct involvement in the housing market. Among the most famous names to go down is the UK's Northern Rock, the first 'run' on a British Institution for 150 years and New Century Financial Corporation in the U.S. The direct support given by the Bank of England to keep Northern Rock afloat is a major policy shift for the current economic thought process.
2. Secondly what has followed is reduction on new lending until banks ascertain their losses and analyse the reasons for the debacle or a 'credit crunch'. This squeeze has affected the equity markets with large transactions held in abeyance. It has also affected interbank lending with lines 'frozen' until the viability of the counterparty has been evaluated. Future market behaviour depends on changes, if any, to the lending criteria of the major players in the global financial markets.
Thirdly a number of large financial institutions have declared third quarter losses for 2007 with ongoing decline in profits for the year bringing about a correction in the Dow Jones. Also affected by the profit decline are various welfare groups which benefited from the social responsibility programmes of large corporate.
The fallout has resulted in just about everyone involved being placed under serious review.
Lenders have been accused of overtly aggressive marketing techniques.
Mortgage brokers have been charged for making clients take unaffordable loans and for "overlooking "income verification to upgrade weak borrowers.
The integrity of appraisers and valuation agents has been questioned for inflating housing values.
Rating agencies have also come under severe criticism for inadequate assessment of the risk and some institutions are contemplating suing such entities which are expected to remain independent of the market.
The wisdom of Wall Street investors who backed sub prime mortgage securities without verifying the strength of the portfolios is under doubt.
The lack of effective government oversight to the problem has caused concern among lawmakers. In the U.K., a country long considered a safe haven for the financial sector, it was revealed that there was no clear line of responsibility for monitoring the banking sector between the three agencies involved -- the Treasury, the Bank of England and the F.S.A. A grilling of the top executives of the latter two by Parliamentary subcommittee revealed that the funding Model of Northern Rock had been considered extreme in March 07 but due to undefined responsibility timely action could not be taken.
Just what is likely to be done to overcome the problem?
One solution suggested is the establishment of a "Super SIV" - a $75 billion Master Liquidity Enhancement Conduit designed to take on the assets of troubled investments, which critics including Alan Greenspan say, carries the risk of further undermining already brittle confidence in besieged credit markets.
Another more recent development indicates that the U.S. government is negotiating an interest rate freeze for the sub prime loans to make it easier for borrowers to repay. Like the U.K this would be direct state intervention to support a troubled market.
In the meanwhile, banks are looking for saviours to inject new equity into their capital base, while the markets brace themselves for a chilling winter.
ONE of the advantages of Dhaka's regulated Foreign Exchange Market is that international shake-ups in the financial world pass over without any effect. It explains why the 07 crisis has received little attention since our financial sector has not yet ventured into the largely unregulated area of commercial paper and securities.
Having recorded the events of the autumn of this year as I watched them unfold in the hard-hit London market, only now does the extent of the devastation become apparent. As a keen observer, it is vital to pass on the ripple effect that the crisis has created in the world-wide economy and the lessons to be learnt from the episode.
The US housing industry was being encouraged by selling loans to less than credit worthy borrowers who were termed "sub prime". The risks relating to the inability of homeowners to make their mortgage payments were distributed, through innovative securitization and globalization, by the lenders to global banks who resold the debt to institutional buyers all over the developed world. One of the features of these home loans was that interest rates were adjustable and would move up or down with the markets. In 2006 there was a rise in U.S interest rates bringing with it an increase in monthly payments on the adjustable rate mortgages. At the same time property values declined and many home owners were unable or unwilling to meet financial commitments. In turn, primary lenders were left without the means to recoup their losses as a result of which the securitized paper lost its value, with more sales than the markets could handle. The sub prime paper was owned, sold and traded by the leading names in the world financial markets and a classic domino effect followed as institution after institution fell victim to the virus. The effects of the meltdown spread beyond the U.S housing markets, disrupting global financial markets as investors, largely deregulated foreign and domestic hedge funds, were forced to re-evaluate the risks they were taking.
The ongoing problems are reported under various names ,the sub prime mortgage crisis, the bubble burst in housing prices, the meltdown in SIV but whatever the name the underlying issue remains the same.
The size of the US sub prime mortgage market is estimated at $1.3 trillion as of March 2007. An extensive review of various reports on the subject indicates that approximately 16 per cent of sub prime loans on adjustable interest rates were 90-days into default or in foreclosure proceedings as of October 2007. A total of nearly 447,000 U.S. homes were targeted by some sort of foreclosure activity from July to September 2007. The estimated value of sub prime adjustable-rate mortgages resetting at higher interest rates is $500 billion for 2008. The availability of these figures brings to mind the inevitable question: Given the large amount lent to a high risk group why hadn't the simple question 'What will happen if house prices go down and interest rates go up' been tested? Given the additional fact that testing is mandatory under Basel 11, which all banks are due to implement by 08, this is even more surprising.
The aftermath till date has been three fold:
1. The most immediate has been bankruptcy and decline in share prices of the institutions involved in the trade. The first to be hit were the mortgage banks with direct involvement in the housing market. Among the most famous names to go down is the UK's Northern Rock, the first 'run' on a British Institution for 150 years and New Century Financial Corporation in the U.S. The direct support given by the Bank of England to keep Northern Rock afloat is a major policy shift for the current economic thought process.
2. Secondly what has followed is reduction on new lending until banks ascertain their losses and analyse the reasons for the debacle or a 'credit crunch'. This squeeze has affected the equity markets with large transactions held in abeyance. It has also affected interbank lending with lines 'frozen' until the viability of the counterparty has been evaluated. Future market behaviour depends on changes, if any, to the lending criteria of the major players in the global financial markets.
Thirdly a number of large financial institutions have declared third quarter losses for 2007 with ongoing decline in profits for the year bringing about a correction in the Dow Jones. Also affected by the profit decline are various welfare groups which benefited from the social responsibility programmes of large corporate.
The fallout has resulted in just about everyone involved being placed under serious review.
Lenders have been accused of overtly aggressive marketing techniques.
Mortgage brokers have been charged for making clients take unaffordable loans and for "overlooking "income verification to upgrade weak borrowers.
The integrity of appraisers and valuation agents has been questioned for inflating housing values.
Rating agencies have also come under severe criticism for inadequate assessment of the risk and some institutions are contemplating suing such entities which are expected to remain independent of the market.
The wisdom of Wall Street investors who backed sub prime mortgage securities without verifying the strength of the portfolios is under doubt.
The lack of effective government oversight to the problem has caused concern among lawmakers. In the U.K., a country long considered a safe haven for the financial sector, it was revealed that there was no clear line of responsibility for monitoring the banking sector between the three agencies involved -- the Treasury, the Bank of England and the F.S.A. A grilling of the top executives of the latter two by Parliamentary subcommittee revealed that the funding Model of Northern Rock had been considered extreme in March 07 but due to undefined responsibility timely action could not be taken.
Just what is likely to be done to overcome the problem?
One solution suggested is the establishment of a "Super SIV" - a $75 billion Master Liquidity Enhancement Conduit designed to take on the assets of troubled investments, which critics including Alan Greenspan say, carries the risk of further undermining already brittle confidence in besieged credit markets.
Another more recent development indicates that the U.S. government is negotiating an interest rate freeze for the sub prime loans to make it easier for borrowers to repay. Like the U.K this would be direct state intervention to support a troubled market.
In the meanwhile, banks are looking for saviours to inject new equity into their capital base, while the markets brace themselves for a chilling winter.