The Subprime Meltdown- An Explanation

The aim of this article is to give an explanation the very popular topic of sub-prime crisis which is frequently in the financial media. We will begin with an explanation of how the sub-prime crisis was created followed by a sequence of events that have taken place and how it is affecting the financial markets.

What are subprime loans?

Subprime loans, also called “B” loans or “second chance loans” are loans originated to borrowers who do not qualify for market interest rates because of problems in their credit history. Borrowers who have a FICO credit score below 620 (on a scale from 380 to 850) are generally defined as sub prime borrowers. Subprime loans are generally considered risky for both the borrower and the lender. It’s risky for the lender because borrowers usually have lower incomes and a poor record for paying debt which increases their default probability. It is also risky for borrowers. To offset the risk of defaults, lenders will charge high rates of interest to offset the risk. The high interest rates however are strenuous for borrowers which further increases their likelihood of default.

Subprime loans were created with the realization that a lot of money could be made to borrowers with poor credit who could not get conventional loans. Conventional lenders would not take the risk to lend to people with credit scores below the firm threshold. This opened many opportunities for subprime lenders to lend to people with below acceptable credit scores. 21% of mortgage applications between 2004-06 were subprime compared to 9% between 1996-04. Subprime mortgages reached a record of $805 billion in 2005. In 2006 they totaled approximately $600 billion.  This has helped boost US homeownership to a record of 69% of households.

There are various different types of subprime mortgages including “interest only mortgages” which allow borrowers to only pay interest for a period of time, “pick a payment” which gives the borrower the option on how to repay the loan and “initial fixed rate mortgages” which convert to variable rate loans like ARM’s.

How are Subprime Loans Originated?

The story begins with borrowers who have a poor credit history looking to buy a house and are prepared to pay a mortgage rate typically 2% higher than rates charged to people with good credit. Borrowers approach mortgage brokers or conversely get brokers to cold call them. Brokers handle approximately 70% of the origination. Brokers match prospective borrowers with lenders who further lure borrowers with exotic mortgages such as “no doc” mortgages, which do not require any evidence of income or savings. Big banks and wholesale lenders such as HSBC Holdings buy the debt, repackage them and sell them to Wall Street firms. Wall Street banks and investment houses further repackage these loans in mortgage backed securities (MBS) and collateralized debt obligations (CDO). These structured products very often yield high rates of return and are sold to pension funds, hedge funds and institutions

 The Crisis

Many economists are blaming the crisis on exuberant brokers who lure borrowers into mortgage deals. These borrowers very often do not understand the types of loans or the contracts they sign, which denies the ability to asses true risk. The problem includes appraisers using inflated figures to value houses. Lack of government regulation has also been blamed as being the cause of the problem.

Lenders very often use independent brokers who originate half of underwritings, of which 70% of them are subprime. The big mortgage houses grow so big that they outsource sales people to a network of thousands of other brokers that grow annual loans by huge proportions. In fact subprime loans are the fasted growing segment of the mortgage market.          

Subprime mortgage brokers were actually protected by a legal leniency. Under US law, investors who buy securities backed by mortgages or even the actual mortgages will not be exposed to lawsuits for fraud. This protection partly explains how the US mortgaged backed securities market expanded at such a rapid pace. MBS’s more than tripled since 2000. Last year was the first time that more than half of the asset backed securities issued were backed by subprime loans.

 Subprime lenders naturally foreclose on properties at a much higher rate than conventional lenders. Statistics show that approximately 3.3% of subprime loans end up in foreclosure compared to 1.1% for conventional loans.  The subprime meltdown is said to have begun in 2006, with escalating number of subprime house foreclosures. Following this over 20 subprime mortgage lenders failed or filed for bankruptcy, the most common one being a company by the name of New Century Financial Corporation, which was the nation’s second biggest subprime lender.  Other well known lenders include Countrywide Financial Corp and HSBC Holdings which started unraveling problems in their subprime portfolio.These bankruptcies cause a general decline in mortgage company stocks creating a general panic in the housing market. Big lenders such as HSBC Holdings used legal cases to force back smaller lenders to buyback bad loans which they originated. This is known as “Repurchase Agreements”.

The relationship between subprime meltdown and house prices is as follows: - As house prices drop, the equity value of home mortgages goes down, this creates an increase in mortgage defaults which will cause a further drop in house prices. This positive feedback relationship will simply create a snowball effect until the economy has reasons to believe that there are reasons for the reverse to happen. The subprime problem could also seep into other sectors in the economy. The housing slump is estimated to be able to strip 1-2 points off the GDP figure, furthermore, the downturn in the housing market will drag down the construction sector which will further affect other industries like plumbing, furniture and home improvements as well as Lawyers. With all this extra worries in companies, investors will pour their money in risk free treasuries. This will induce more money to be pulled out of junk bonds and loans to finance leveraged buyouts.

 In March 2007 General Motors surprised investors by announcing that earnings plunged 90%during the first 3 months of 2007. The reason was due to losses at its mortgage loan subsidiary GMAC. Although the firm posted its highest profits in three years, the $651 shortfall at GMAC overshadowed any gains in its core business.  UBS said that it will shut its Dillon Read Capital Management arm after the hedge fund lost 150 million Swiss Francs on subprime investments. On March 13^th 2007 the Mortgage Bankers Association reported a record percentage of mortgaged homes entering into foreclosure. This caused the S&P 500 to tumble 2%.

On June 21^st 2007 data was released showing the record number of foreclosures, with the biggest increase in the subprime sector. In the same month JP Morgan Chase announced problems with two hedge funds which were heavily leveraged in CDO’s with high exposure to subprime debt. The two hedge funds were announced to close down which caused further panic in the subprime sector.

One month after Standard and Poor’s announced that it will cut credit ratings on nearly $12 billion worth of bonds backed up by subprime loans. It is interesting to note that many of these rating agencies have been criticized for not being assessing a realistic credit rating to reflect the high likelihood of default. All these news announcements led to a drop in the US dollar, which allowed the dollar to drop to a 26 year low versus the British Pound.

Many however are not so worried about the foreclosure rates because economists believe that the crisis is due to lax underwriting and not due to troubles in the economy. Overall the economy is doing well with employment rising. Economists more bearish however are concerned that the subprime crisis will be a catalyst for a housing market crash. There was a Joint Economic Committee of Congress which reported the potential impact of foreclosures on various local communities. Charles Schumer as well as other senators tried to convince the US government to help troubled borrowers pay back their loans. This was however very rightly criticized by many economists. The response was that it will create a moral hazard were borrowers in the future will lack the incentive to be careful on their loans. The problems will increase further if borrowers decide to default on their debt with the hope that the government will bail them out.

Bernanke responded to the crisis by prescribing methods to regulate the mortgage industry and enhancing laws where high levels of due diligence is needed in assessing borrowers ability to pay as well as make sure there is a much clearer understanding on the terms of the loans. These guidelines were put forth in June 2007 with the hope to prevent or at least reduce fraud and abusive lending in the future.

 June 27, 2007

Continue to The Suprime Crisis Part II: Recent Events