The Subprime Saga: Myths & Truths
INTRODUCTION
Lending done by banks and other financial institutions can be classified as prime lending and subprime lending depending upon the quality of borrowers. Quality of borrowers can be ascertained on following basis:
- Creditworthiness of borrower (depending upon its credit history)
- Risk attached with credit
- Borrowers demographic profile
- Interest rate on loan
- Documents submitted/ terms of loan
- Legal compliance & regulations
Generally borrower qualifies for the loan with overstatement of income or reduced documentation. That’s why they are also called “liar loans” or “no doc” loans or “low doc” loans.
HISTORY
The inception of subprime market can be traced back to 1990s in U.S. The housing boom in 2001 provided tremendous impetus to subprime lending market. Market forces like low mortgage rates, boom in real estate market and increased liquidity in the economy have enticed many non-bank lenders in U.S. who are not subject to federal regulation to enhance their loan with sub-standard practices & relaxed documentation to tap the market.
Street firms provided these lenders with capital by buying up subprime mortgages, converting them into securities and selling them to hedge funds and PE investors for high returns. As a result subprime borrowers jumped from 8% to total mortgage backed loans in 2003 to 20% in 2006. There are now $ 1.3 trillion subprime loans outstanding up from $ 65 billion in 1995 to $ 332 Billion in 2003.
JUSTIFICATION
All markets globally follow two basic economic principles i.e.
Ø Demand & Supply
Ø Risk versus return
In stock market scrip which is in demand will trade at higher price, similarly risky scrip will generate higher return. In wider terms, investing in capital markets generates higher returns than in risk free securities like G-sec or T-bills. Similarly a less creditworthy borrower represents a riskier investment & for his risk lender will charge a higher interest rate than prime market.
From the borrower point of view they get the loan to fulfill their needs and that too at their terms and conditions. To do away with higher interest rates initially go for ARM (Adjustable Rate Mortgages) in which they give very low initial interest rate for initial 2 or 3 years which is increased to substantial rate for remaining repayment period of 30 years life of the loan (Life of loan is usually 20 – 30 years).
TERMS OF SUBPRIME LENDING
The rates and fees charged by subprime lender is higher than that of prime lenders but the basis for levying the rates is same. It is simply and directly related to risk with the loan. Lower the credit scores or smaller the down payments higher will be the rates. Since there are more chances of defaults in subprime lending and higher costs (because more applications are rejected and marketing costs are also higher) so entire structures of rates & fees is higher than the prime lending to cover greater risks and higher costs.
SUBPRIME LOANS TO PRIME LENDERS
Subprime market is boon for the loss of class of people who does not qualify for the prime market but bane for those borrowers who are eligible for mainstream borrowing but end up borrowing in subprime market. This may be because of various reasons like:
- Due to difficulties and ambiguities regarding borrower to determine whether they qualify for prime lending terms or not.
- Underwriting and documentation requirement may differ from one lender to another.
- Lack of financial knowledge and market awareness on the part of the borrower. Potential buyers are tapped by subprime lenders before they even contact prime lenders. This practice is commonly known as “steering”.
POSITIVE SIDE OF SUBPRIME LOANS
We generally find mere critics of subprime lending than advocates. If we look into facts then subprime lending have helped boost U.S. homeownership to a record 69% of households. They help the borrower of low income profile who struggle with the poor ratings/scores or have excessive credit cards or other debts. They provide homeownership to those who can’t afford, indirectly boosting the economic growth.
It can be summed up as:
- Homeownership to those who cannot afford as per prime lending norms.
- They provide flexible interest rates (ARM’s) and small down payment.
- Responsible for boom in real estate sector
- Followed by corresponding booms in related sectors like cement, construction equipments, home requirements, etc.
- This in turn increases the overall pace of economic growth.
PHENOMENON OF SUBPRIME CRISIS
Economics: Subprime market develops with supply and demand gap between aspirants of owning the house and desirous people to lend the money. Since aspirants of house buyers have poor credit rating i.e. high probability of defaulting on repayment, so lender will charge significantly higher interest rates both because of supply crunch and to cover high default risks. The prospective lender takes a loan from the banks/institutions at relatively low rate (because of his good credit ratings and high bargaining power) and lends money at higher rates in subprime market. Thus he ensures higher returns and risk mitigation by giving out loans to many people.
Refinancing: It is another important feature of these loans. Loans are denoted as 2/28 or 3/27 meaning that for initial 2-3 years interest rates are significantly low and then they become adjustable or variable for the remaining term of 27-28 years. When the economy is booming and real estate sector is doing well, refinancing is easy. Every 2-3 years borrowers refinance their loans, thereby maintaining same cost of loan. The lender on the other hand securitizes the loan by issuing mortgage backed securities which are marketable in small lots and sells them to investors with a promise to pay interest on these securities. Money collected from investors is used by entrepreneur to repay bank loan. The interest and principle payments for the investors of MBS are met by installments collected from home loan borrowers every month.
Vicious Circle: Rising interest rates will create double whammy for home loan borrowers. Now they are not in a position to pay higher installments and refinancing (as they had been doing earlier) also becomes impossible because of falling real-estate prices. This will create defaults on the part of borrowers because of their low income profile. With the defaults on the hand of borrower, repayment also stops which were used to make interest payments on MBS. This instigates investors to pressurize entrepreneur who issued MBS. Now if entrepreneur is by enough and diversified into other activities he somehow manages the show otherwise he files for bankruptcy.
On the other hand investors which are generally institutional investors – hedge funds, PE funds, etc would go bad. Funds with global exposure have percentage allocations to various geographical locations. In case U.S. exposure turns bad, the funds start pulling out of profit making markets which are generally developing countries. This helps fund in two ways, firstly keeping the percentage allocation as per requirements and secondary meeting the redemption requirements in U.S. market.
Here starts the vicious circle. As the real estate prices fall, defaults increases because no refinancing is available. With the increase in defaults, lending rate increases (because now lending is stricter). As lending slows down, the flow of money to the sector falls sharply. This leads to further decline in prices of real estate and thus starts a cascading effect in whole economy.
GENESIS OF PRESENT CRISIS
U.S. is the birth ground of present subprime crisis and is most hit by this crisis. The main reason was incipient inflation in U.S. economy and Federal Reserve increasing the various policy rates after 2004. Fed increased its fund rate (overnight rate at which banks lend to each other) from 1% to 5.25% and discount rate (rate at which Fed lends to banks) from 2% to 6.25%.
This increase in rates drastically increased the payments made by holders of the mortgages. This proved disastrous for institution providing subprime loans. To mitigate the impact of crisis Fed has decreased the discount rate by 50 basis points to 575% on August 17.
PRESENT SCENARIO
As per Mortgage Bankers Association of U.S., last year 13.5% of mortgage originated in U.S. were subprime compared to 2.6% in 2000. By the end of 2006, subprime delinquencies more than 60 days jumped to 13% as compared to 8% in 2005.
We can say that U.S. subprime mortgage loan market is currently undergoing a sharp correction. It has hit by major shocks in last six months. It is estimated that 127 lenders are hit by this crisis. Around twenty specialized lenders have gone bankrupt.
Credit rating agencies have started reassessing the rating already given and degrading if required.
IMPACT ON U.S. STOCK MARKET AND COMPANIES
The stock of all the companies related to sub prime market fall drastically. Many companies issued warning lowering profit estimates for example HSBC had to very substantially increase its loan loss provision in second half of 2006 and first half of 2007 leading to its first ever profit warning.
The shares of Countywide Financial Corp., the largest mortgage lender in U.S., fell by 13% after it issued profit warning.
Accredited Home Lenders announced to cut workforce to 1000 from 2600 employees at present.
Shares of all the major home lenders fell on 22nd August 2007 when U.S. biggest subprime lender said that it will hibernate until the home lending market recovers. Few major falls can be illustrated by:
Ø Shares of Accredited Home Lenders sank 45 cents, or 6.9 percent, to $6.10.
Ø Shares of Countrywide Financial Corp. slipped 3 cents to $21.82.
Ø Shares of H&R Block dropped 35 cents to $19.44.
Ø Shares of Thornburg Mortgage Inc. fell 25 cents to $12.84.
Ø Shares of IndyMac Bancorp rose 95 cents, or 4.2 percent, to $23.45.
Ø Shares of NovaStar Financial Inc. gained $1.51, or 20 percent, to $9.08.
Swiss bank UBS reported a net fourth-quarter loss of $11.3. The bank’s loss exceeded fourth-quarter losses posted by other major lenders hit hard by subprime woes, including Merrill Lynch & Co., $9.91 billion and Citigroup Inc., $9.83 billion. UBS said it still holds $27.59 billion in securities linked to the US subprime residential mortgage market, down from $38.77 billion in September.
PREDICTED TRENDS IN United States
According to “Moody’s Economy.com” there will be 2.5 million mortgage default this year. It expects delinquencies to peak in summer of 2008 at 3.6% of all outstanding mortgage debt up from 2.9% during first quarter of 2007.
Foreclosures: According to “Moody’s Economy.com” subprime ARM’s will be the worst hit loan category. The foreclosures on these loans are expected to hit 10% by mid of 2008 which are currently at the level of 4% & were just 2.5% in 2005. Subprime ARM issued during last three months of 2006 is worst of all, with projected foreclosure to reach 20% by 2011.
There were 179599 foreclosure filings in July 2007 throughout U.S. showing 9% rise over previous months and a 93% jump over July 2006. 43 states experienced rise in foreclosure activity. Navada has the highest rate of foreclosure at 1 per 199 households while California has maximum number of total foreclosures at 39013.
Adjustable Rate Mortgages: to worsen the situation, more than two millions subprime ARM’s are poised to reset at much higher rates in coming months. Borrowers who took ARM’s in 2004 and 2005 may see their monthly mortgage climb by 35% or more. Those who will not able to pay high installments will ultimately use their money. As per “Moody’s Economy.com more than two million subprime adjustable rate mortgages (ARMs) are poised to reset at much higher rates in coming months of 2007.
To date, major banks have disclosed more than $140 billion (U.S.) in losses tied to mortgages, complex debt and other bad credits. As estimated by analysts total write-offs could reach $400 billion, suggesting that the barrage of bad banking sector news is likely to continue.
The deadline for most publicly traded U.S. banks to file annual reports with the SEC is Feb. 29. Many already revealed heavy losses when they issued fourth-quarter results in recent weeks, but these final year-end reports face closer scrutiny from accountants and could contain some new shocks.
IMPACT ON INDIA
As per the statement given by former SEBI chairman M. Damodaran, there is no direct impact of subprime crisis on Indian banks or Indian stocks markets. But it is well said that “Even if America sneezes, India catches cold”.
Subprime crisis in the most developed country of the world will definitely have an impact on other nations the extent may be a question to ponder upon.
Sensex witnessed some biggest falls in last few months responding to global stock markets such as:-
- Jan 21, 2008 – 1,408.35 points.
- Mar 3, 2008 – 900.84 points.
- Jan 22, 2008 – 875.41 points.
- Feb 11, 2008 — 833.98 points.
- May 18, 2006 – 826 points.
- Dec 17, 2007 – 769.48 points.
- Oct 18, 2007 – 717.43 points.
- Jan 18, 2007 – 687.82 points.
- Nov 21, 2007 – 678.18 points.
- Aug 16, 2007 – 642.70 points
The falling spree of the Sensex can be explained by heavy selling of Institutional investors. FII’s pull money out of emerging markets like India to make good of their losses in subprime markets.
Banks & FIs
The collateral damage to India as a result of the sub prime crisis is extremely limited since Indian banks do not own structured finance instruments
As per HDFC Bank chairman Deepak Parekh, Indian banking system is unlikely to be affected by subprime crisis.
If there is overall slow down in global growth will have some impact on Indian growth and a fall in global liquidity will impact India’s ability to finance future growth.
CONCLUSION
The development of subprime market has made mortgages and home ownership available to segment of population that otherwise would not have accessed the market. Though subprime lending is important growth engine but one should take lessons from the crisis and enact proper safeguards to avoid such situations in future. The points to be taken care and work upon, from the present crisis are:
- The way in which banks and financial institutions lends money to the public without properly checking their credentials and records.
- It causes losses not only to the direct and indirect stake holders (lenders, borrowers, investors etc.), but it effects the society and economy at large.
- The regulators should control ineffective and immoral credit rating process.
Subprime market crisis is essentially an American crisis but in today’s era of globalization and communication no country can isolate its financial system and if U.S. economy is hurt, it will definitely have negative impact on global trade.
Social experts or governments should not justify subprime lending on basis of its relationship with home ownership because most of the subprime loans are used for refinancing purpose or are availed by existing home owners buying another home. This defeats the basic rational given for promoting subprime lending.
Throughout globe governments should learn from this crisis and should take necessary steps to all parties in all parties in subprime lending game under regulatory framework which presently may not be under any legislation.
