Crisis in US Sub-Prime market

INDUSTRY COMMENT by Theuns Hanekom

We keep hearing about how the sub-prime crisis in the US housing market has caused great anxiety in the world economy. What is it and how will economies manage the crisis?
Remember 2001 in the USA - 9/11, huge corporate scandals (Worldcom and Enron)? Remember a fear in the US of recession? The US Federal Reserve cut interest rates to an all time low of 1% to stimulate their economy. Of course, lower interest rates made houses more affordable and house prices soared as demand for properties increased.

The prime rate of interest is the rate at which banks loan money to their low risk or best risk clients. With this demand for borrowing for housing purchases, US mortgage lenders saw the potential of granting high interest home loans to previously high-risk clients who might not have qualified for a mortgage loan under normal circumstances. So the birth of the sub-prime lending market. Sub-prime lending gave rise to a whole range of new mortgage products, which effectively did away with the usual strict credit criteria. “Liar loans” (allowed applicants to claim higher income) and “Ninja loans” (no income, no job or asset loans) were products offerings. Lenders argued that they could charge higher rates to compensate for the increased risk of their new clients and relied on a booming property market to protect them in the event of default and the need to repossess. Also important is that sub-prime lenders largely made use of securitization to raise funding.

By December 2004, however, US interest rates were increasing causing bond repayments to rise and the growth in property values to decline. The high-risk sub-prime market was the first to feel the pinch of higher interest rates and subsequently defaults on mortgage repayments started to soar. Sub-prime lenders struggled to sell repossessed properties at a high enough price to cover the outstanding debt. This resulted in huge losses in the sub-prime market. It was recorded during February 2007 that sub-prime mortgage defaulted at a rate of 12.5% as opposed to 1.5% of traditional prime mortgages.

As mentioned earlier, the decision to enter into the sub-prime market, was fuelled by investors and the highly lucrative securitization model. As the sub-prime market started to default, investors in mortgages started to panic and withdrew their investments in mortgages. This caused a liquidity squeeze, as many of the sub-prime lenders were forced to liquidate their sub-prime mortgages in order to pay their investors. This forced further losses in the sub-prime market. During April of 2007, New Century, the largest independent sub-prime lender filed for bankruptcy.

How does this affect the South African market? Fortunately our major financial institutions have not yet entered the sub-prime market. It is unlikely that South Africa will be directly exposed to a sub-prime crisis. This is due to disciplined banking practice and more recently introduction of the National Credit Act. However as members of the global economic community we cannot escape the effects of the crisis in the largest economy in the world.

However, as a result of the US sub-prime crises, certain recommendations are being investigated in order to prevent this from happening again in the future. One recommendation, which may be investigated by our local financial institutions, is separation between the origination of the credit (mortgage originator) and the ownership and management of the associated credit risk. There is a growing concern that the mortgage originator is not motivated or involved in limiting the risk associated with the mortgage loan.

With the rise in interest rates over the past 19 months and banks recording a sharp increase in repossessed properties, the banks may very well investigate ways of sharing that risk with the mortgage originators in the future, such as the introduction of trailer commission which is currently being used in the Australian mortgage origination market. This, however, reiterates our role as mortgage originators – we have an obligation towards the banks to ensure that we submit good quality applications in order to ensure the sustainability of our wonderful industry.