U.S. Subprime loan Issue Essays

U.S. Subprime loan Issue Essays U.S. Subprime loan Issue Essay U.S. Subprime loan Issue Essay The purpose of this report is to analyze the reasons of the sub-prime crisis, which has created worldwide financial market problems in recent time. The main Sub-prime issue will be focused in the US, but global impact throughout the world and examples from the Australian Financial markets will also be discussed. Sub-prime lending originated in the US and had evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it coupled with the unwillingness on the part of legislators at the national level to recognize the inherent risks to consumers (wikipedia, 2008). In recent years, sub-prime lending had increased significantly due to several factors. Such as the housing downturn-housing bubble, carelessness of financial institutions and credit agency when lending money to sub-prime borrowers, the increasing practice of securitizations and hedge funds. These factors contribute to sub-prime crisis problems faced by the world now. The impact of the sub-prime crisis causes great losses to financial institution and some had even filed bankruptcy. The economy now is also facing credit crunch, which decreases economic growth. Financial institutions and companies such as Australian New Zealand Bank (ANZ), Macquarie Bank, Centro Properties Group and ABC Learning Centre are given as examples to demonstrate the impact of sub-prime crisis in Australia. Information for this report is taken from electronic newspapers, magazines and Internet articles. As a conclusion, due to the credit squeeze that results from the sub-prime loan issue, banks will increase interest rate for loan and will be more careful and strict in providing loans to the borrowers. Stock price will continue to decline, as investors will not want to invest their money in high-risk investment. However, investment in Australia will increase as investors see that Australia being a more stable economy is more attractive than US in the meantime. 2 Introduction 2.1 Background information Sub-prime loan is a type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. The additional percentage points of interest often translate to tens of thousands of dollars worth of additional interest payments over the life of a longer-term loan (investopedia, 2008). Sub-prime lending originated in the US and had evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it coupled with the unwillingness on the part of legislators at the national level to recognize the inherent risks to consumers (wikipedia, 2008). Having emerged more than two decades ago, sub-prime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances make it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers (Bernanke, 2007). The ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations. Whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities. The growth of the secondary market has thus given mortgage lenders greater access to the capital markets, lowered transaction costs, and spread risk more broadly, thereby increasing the supply of mortgage credit to all types of households (Bernanke, 2007). The value of U.S. sub-prime mortgages was estimated at $1.3 trillion as of March 2007 (associated press, 2007), with over 7.5 million first-lien sub-prime mortgages outstanding (Bernanke, 2007). 3 Body 3.1 Reasons for the Sub-prime loan crisis 3.1.1 Housing downturn- housing bubble As shown in figure 1 and 2 in appendix 1, due to increasing stocks value and decreasing interest rates, since around 2001, house prices have soared way above the current housing price. Homeowners have seen their wealth climb due to the increase in selling price of the house (time magazine, 2005). Thus enabling them to buy a second home under a sub-prime loan, thinking that they will get a more favourable terms as rising house price usually occurs for a long period of time. The amount of outstanding loan secured by mortgages increased significantly (time magazine, 2005). After an amazing four-year boom in residential real estate, the housing market could finally be topping out and heading for a downturn (Coy et al, 2004), which is when the bubble burst, around 2006, the prices of the house fell. Demand for housing decline and there is an oversupply of housing, which results in low housing price. The borrowers, facing the risks of being unable to pay the monthly loans choose to default , which increase foreclosures, thus causing losses to the major lenders. As shown in figure 3 in appendix 1, the housing bubble reached its peak in 2005, and started to deflate in 2006 and accelerated since. According to Lahart (2007), In June 2006, sales of existing single-family homes were 9% below their year-earlier level, sales of new homes were down 15% and framing lumber prices were down 19%. 3.1.2 Roles of financial institutions Due to moral hazards and lack of supervisions by the regulators, the regulations of providing loans to sub-prime borrowers become less strict. Therefore, many major mortgage brokers, accepts borrowers with very poor credit risk in order to get bonuses as they steer borrowers to very high interest rates. As shown in figure 1 below, sub-prime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300% (investopedia, 2008). Figure. 1 Sub-prime mortgage origination Source: investopedia.com These mortgage brokers give loans to borrowers at an adjustable rate mortgage (ARM) where interest rates are periodically adjusted based on a variety of indexes (Macdonald, 2004). In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. One example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Another example is a payment option loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004-2006 had teaser rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment (Trehan, 2007). Due to the decline in housing prices and inflation, the Federal Reserve increases interest rate. Thus, in order for the lenders to maintain profits, they set a higher interest rate (ARM) which results in people defaulting their mortgage, increasing foreclosures. 3.1.3 Role of credit agency Credit rating agency (CAR) mainly the Standard Poors (S;P), Moodys Investors Service and Fitch Group had assures collateral debt obligation (CDO) buyers the quality of the investments as each had blessed most of the CDO with the highest rating of AAA or Aaa (Tomlinson Evans, 2007). As shown in Figure 2, the value of the once rated AAA CDO had been decreasing below par value. Banks that had been underwriting MBS and CDO admitted $30 billion in losses. Citigroup estimates that big banks may be facing $64 billion write-downs, excluding its own figures- Citibank was one of the top two underwriters of CDOs (The economist, 2007). Figure. 2 credit rating on sub-prime performance in 2007 Source: economist.com 3.1.4 Role of Securitization In the mortgage market, securitization converts mortgages to mortgage- backed securities (MBS) (wikipedia, 2008). These MBS are sold to investors and the secondary market as securities so that the mortgage originators will be able to pool more funds thus can lend to many more borrowers, increasing profits. Investors now bear the related credit default risks of the mortgage payment. The MBSs are structured so that interest payments on the mortgages are at least sufficient to cover the interest payments due on the bonds. Principal payments on the mortgages are used to pay down the principal on the bonds. Since investors can invest in MBSs directly or indirectly (e.g., through mutual funds), these asset-backed securities allow a broad investor base to help fund home mortgages. In part for this reason, an increasing share of home mortgages have been securitized, with the ratio of MBSs to total mortgages now over 50% as shown in figure 3 below (wessel, 2007). Figure 3 Increasing share of securitized home mortgages Source: http://economistsview.typepad.com 3.1.5 Hedge funds Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. There is a type of hedge fund strategy known as credit arbitrage which involves purchasing sub-prime bonds on credit and hedging these positions with credit default swaps, it increases demand for Collateral debt obligation (CDO). Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls (investopedia, 2008). 3.2 Global impact The shock waves emanating from the sub-prime mortgage earthquake are now spreading around the financial world. The collateral damage is being unveiled so quickly that it is difficult keeping up with all the collapsed hedge funds, injured banks, and defaulting mortgage brokers (Numerian, 2007). 3.2.1 Credit crunch and the effect in the banking sector The credit crunch was sparked as a result of the housing slump, rising interest rates, and record defaults in the sub-prime sector of the United States, and over recent weeks the global repercussions of this crisis have become increasingly evident. The credit crunch affected the Northern Rock bank in Britain most. When the fact of the credit crunch was discovered, many of the banks 1.5 million savers queued at all hours of the day and night in order to withdraw their savings amidst fears that the bank might be on the verge of collapse (Kenny, 2007). The run on the Northern Rocks continued for days, despite the Bank of Englands intervention with a guarantee of deposits (Long, 2007). In the space of a few days, over two billion pounds was withdrawn from Northern Rock by worried savers. Not only did this damage the company financially but it also did not favours in terms of its reputation, and many experts predicted that even if the bank survived the financial losses it would not surviv e the damage to its reputation. Northern Rock also saw its share prices plummet at the start of the chaos, with over 80% being shaved of share values (Kenny, 2007). 3.2.2 Effect in hedge funds Bear Stearns, the New York investment bank, announced that two of its hedge funds had invested in these sub-prime bonds, and were now broke. Bear Stearns for one of its funds had raised about $600 million in cash from investors, but then borrowed over $5 billion more from banks to leverage up the profits in the fund. They lost $600 million immediately due to the accelerating price depreciation (BBC news, 2008). 3.2.3 Effect in equity markets Stock is a form of equity instrument. Due to the crisis and increase in interest rate, stock prices have fallen significantly. Causing loss to many financial markets and institutions. Stocks like Mizuno Bank of Japan have dropped 10% or more merely from announcing some losses in their investment portfolios. In the case of American Home Mortgage Investment Corp., that stock has fallen 90% amid market rumors that the company is facing bankruptcy (Numerian, 2007). Another example was the Thornburg mortgage (TMA); a stock exchange company was forced to sell off $21.9 billion of assets to raise cash as its stock dropped 65% in two-and-a-half weeks in 2007. (Steverman, 2007). In 2008, within 3 months time, the share price had decreased by 85.10%. 3.2.4 Effect in financial institutions Due to the heavy investments in the MBS and CDOs in the US market, many financial institutions including banks, investment banks, hedge funds, mortgagers have suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of April 3, 2008 financial institutions had recognized sub-prime-related losses or write-downs exceeding U.S. $210 billion (wikipedia, 2008). As shown in table 1, the top 3 banks that suffer the greatest amount of MBS and CDOs loans are the UBS AG ($37.77 bln), Citigroup ($24.1 bln), and Merrill Lynch investment bank ($22.5 bln), (BBC news, 2008). Table 1 Write-downs on the value of loans, MBS and CDOs MAIN CREDIT CRUNCH LOSSES UBS: $37.4bn Merrill Lynch: $22bn Citigroup: $21.1bn HSBC: $17.2bn Morgan Stanley: $9.4bn Deutsche Bank: $7.1bn Bank of America: $5.3bn Bear Stearns: $3.2bn JP Morgan Chase: $3.2bn BayernLB $3.2bn Barclays: $2.6bn IKB: $2.6bn Royal Bank of Scotland: $2.6bn Credit Suisse: $2bn Source: Company reports Source: ;http://news.bbc.co.uk; 3.3 Impact in Australias Financial Market According to analyst, the exposure to the US sub-prime mortgage market will not produce significant losses for the Australian banks, market conditions for credit have tightened in recent weeks. Australian banks are typically reliant on wholesale funding for a large part of their total funding requirements. The cost of accessing the wholesale market has also increased. If prolonged, the current liquidity crunch could impact the ability of Australian banks to do business through higher funding costs and, potentially, result in difficulty refinancing debt as it matures, particularly commercial paper. The latter is likely to be more of an issue for the smaller institutions (anonymous, 2007). However, not only banks are affected. Many companies are also exposed to the sub-prime crisis, as discussed in the examples below. 3.3.1 Australian New Zealand Bank (ANZ) The Australian New Zealand Bank (ANZ) has boosted its forecast provisions for bad and doubtful debt to $975 million, mainly due to a higher collective provision charge (herald sun, 2008). Due to the effect of the credit crunch, ANZ will bolster its variable lending rates by 20 basis points in order to cover the banks profit margins and protect earnings from the sub-prime fallout, analysts predict (Murdoch, 2008). The news sent ANZ shares tumbling. They closed down 6.6%, or $1.55, at $22.01. Rival banks were also on the slide, with National Australia Bank shedding 4.7%, or $1.46, to $29.64, Westpac falling 4%, or $1, to $24.13 and Commonwealth Bank losing 3.12%, or $1.42, to $44.06 (Zappone ; Saulwick, 2008). As shown in appendix 3, the ANZ share in the stock market have been declining since 2007, although there is a little variation in the increase and decrease of the share price. The ANZ share price have decreased from around $32.00 to $ 20.9400 as of 11 April 2008, however, there is a 1.8% increase in stock price compared to the previous day (the age, 2008). 3.3.2 Macquarie Bank Macquarie Securitization is Australias fourth-largest issuer of residential mortgage-backed securities, according to Standard Poors. The top three are St. George Bank, Commonwealth Bank of Australia and Challenger Financial Services. It has about 2.5 percent of outstanding housing loans in Australia (Thomas ; Lefort, 2008). Macquarie Bank Limited announced on 5 March 2008 that Macquarie Securitization Ltd would wind-back its Australian residential mortgage origination services for both retail and wholesale customers due to the significant increase in the cost of funding mortgages and current conditions in the global mortgage securitization market, but would continue to provide full service to Macquaries existing Australian customers who hold 95,000 loan facilities (Macquarie, 2008). Given the current conditions in the global credit markets and low investor sentiment, Macquarie Banks share price has suffered a similar fate to other big banks in Australia, falling nearly 40% since its high of $83.59 in January (Australasian Investment Review, 2008). As at 11 April 2008, Macquarie Group Limited share was $ 54.7900, which is a 4.5% increase since the previous day, as shown in appendix 4 (the age, 2008). 3.3.3 Centro Properties Group The global credit crunch broke out of the banking sector for the first time, sending Australias second-biggest shopping centre owner into crisis and wiping more than $50 billion off the stock market. Shares in Centro Properties Group collapsed by 76 per cent after the company admitted it had been unable to refinance $3.9billion worth of maturing debt in the risk-averse credit markets. Centro, which ranks second to Westfield in the Australian shopping mall market with 124 centres containing 7000 individual stores, said it had suspended withdrawals from its unlisted property trusts, freezing almost $2 billion worth of investors funds (Condon, 2007). The share price of Centro Properties Group is $ 0.46 as at 11 April 2008, with 0% change since the previous day (Centro, 2008), as shown in appendix 5. The share price had dropped significantly; causing great loss to investors and today, it is on the surge of bankruptcy. 4 Conclusion In conclusion, if the housing price continues to decline, many more banks and companies will face bankruptcies. Economic growth will also slow down due to credit crunch, thus many of the worlds central bank will cut off interest rate in an attempt to counter the credit squeeze. Prices of stocks will continue to decline, as people will not invest their money in high-risk financial market. Banks will increase rules and regulations in lending requirement, thus making it hard for prime borrowers to make a loan. Banks in order to lessen the default risks faced when providing loans will impose higher interest rate loan to borrowers. As Australia is not greatly exposed to the effect of the sub-prime crisis, the economic growth will not be much affected. In fact, domestic investments in Australia will rise, as foreign investors will see that investing in Australia more attractive, compared to the US. In the long run, will appreciate the rate of Australian dollar in respect to other foreign c urrency.