banking and economics
American sub-prime crisis: should the rest of us care?
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This article will be featured in Home Finance: All you need to know about home ownership at rocket finance on Friday.
It should be no news to anyone that there is currently a sub-prime mortgage crisis in the good old United States of America. It’s been on the news, and in the papers for months already.
But, does it really matter to non-Americans? And if so, how?
what is a sub-prime mortgage?
In order to persuade a bank to lend an extremely large sum of money to buy a house, you generally used to need a few things:
- A sizeable deposit
- A verified income
- A house in mind, in fit condition
- A good credit score
In the olden days, it used to be almost impossible to get a mortgage without these things. But then, someone realised that there were likely to be people with deposits, incomes and satisfactory houses in mind, who just didn’t quite have a good credit score.
The idea was that you could offer them a mortgage at a higher interest rate than normal, to offset the greater risk of default. Then people who could afford to buy houses (they had enough income) wouldn’t be cut off from the mortgages they required. The sub-prime mortgage industry was born.
what went wrong?
Quite simply, more sub-prime mortgages holders defaulted than expected. There are various structural reasons for this, to do with mortgage backed securities and other financial products (for more information check out this explanation).
As mortgage holders defaulted, the people they owed money to had to write off lots of debt. This included British banks such as HSBC, who had a sub-prime mortgage unit Decision One Mortgage. They lost in the region of $945m and last February made their first ever profits warning (that they wouldn’t make as much money as expected).
Although the defaults had an impact, they haven’t directly had much effect over here as US sub-prime arms of British banks were generally small.
what happened next?
The number of defaulting mortgages was unexpected, and by this time, the money was owed to many different investors - particularly banks - forming part of their assets (a bit like buying a bond). They realised that they didn’t quite know how much liability they were likely to have, and what the return would be on their investments.
It is thought that this the caused banks to be more wary of making loans to each other, or make them at higher rates, as they were unsure of both there own and everyone else’s true financial position. In any case, credit is in short supply - a credit crunch.
has the credit crunch had an impact?
Yes. Most British banks raise their money for loans from the deposits of their customers, but not all do so. Some, instead borrow the money on the credit markets (effectively from other banks) and then re-lend it to members of the public.
As you can imagine, if it is harder or more expensive to buy money, but you are still lending it out, you’ve got something of a problem on your hands. Which is exactly what Northern Rock realised in September. They were forced to borrow from the Bank of England, which led to a short run on Northern Rock branches as lots of people queued up to withdraw their savings.
In order to prevent a panic (or something) the government announced that they would guarantee the deposits - Northern Rock pretty much had enough money to cover it all, but it would have been the end of the bank. This mess is still in the process of being fixed.
The other important but less obvious impact of the credit crunch is the general impact on the economy. Developed economies are somewhat linked together, and with increasing globalisation, if something effects one of the biggest world economies, it tends to affect everyone to a certain extent, especially if they are a major trade partner.
In addition, the financial sector is one of the powerhouses of the British economy, and this crisis directly affects them. This is probably one of the causes of the recent stock market slides.
any more bad news?
In a bid not to get caught out in the same way that the Americans have been, British banks and building societies are tightening their criteria for mortgage lending. People on the margins are finding it harder to get new financing. Having a good financial footing with low or no consumer debt is more important than ever, if you are trying to qualify for a mortgage. But then, it’s good practice to get rid of as much debt as possible before taking on a mortgage.
Image by yananine.
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30 comments for “American sub-prime crisis: should the rest of us care?”
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Great, clear explanation Plonkee. Many people might feel that the US mortgage market doesn’t affect them, but this explains how it could.
Do you reckon the current stockmarket volatility has largely been caused by the credit crunch?
I thnk that it’s certainly a strong contributory factor. Lack of credit becomes an indicator for a recession, and if everyone thinks there’s going to be a recession, then it affects the stock market. Of course it could have happened anyway, high finance is quite mysterious.
Maybe this is a good thing and will get us all back to our roots. We are an instant gratification society, unlike our parents and grandparents…living on credit and living above our means is causing all this. Yes, this will affect the rest of us too in one way or another. Those of us who will not have to move in a few years or have to refinance our mortgages are luckier than others.
As far as why these loans are affecting our financial markets? Because many were bundled into securities, even being sold overseas and what everyone thought were A-rated loans were in actually not at all. Why? Mostly because banks were giving out loans w/out income verification…those were being given out like candy when we bought our home 3 years ago…so they slap an A rating onto your loan because you SAID you make so and so much money…ooops…how stupid is that?
What I don’t understand…is why NO ONE foresaw any of this possibly happening? Why?
I think that no one really forsees the impact of systemic failings like this. Everyone is relying on everyone else to understand their own part, and it becomes a bubble - which naturally bursts.
Good post.
I think another problem is that the subprime loans were actually being made at low interest rates which not only encouraged larger mortgages but didn’t make economic sense from the lender’s point of view.
Mike
Certainly it looks as if they were being made too low for the risk that was involved. Also, if you’re offering an ARM, then you base your long term on the adjusted rate. The fact is that more people than expected couldn’t afford the adjusted rate - the risk wasn’t sufficiently priced in.
The problem was that no one had a good grasp on the level risk associated with these mortgages, the people that had the risk were many steps removed from the borrowers, and the people that knew the borrowers were many steps removed from the risk.
I don’t think it was really a question of why this wasn’t foreseen; it was definitely known to be a possibility, but the risk seemed less important than the potential return.
I bought and sold my home in Southern California during the most recent real estate Gold Rush, and was one of the folks who took out terrible loans just to get in - a zero-down mortgage with an ARM after 2 years (a first with a 13% interest rate and a second with a 7.5% rate), gambling (and I use that word very deliberately) that I could refinance or sell for substantially higher than what I paid.
In fact, I did.
What is not often highlighted is this was all driven by the idea that anyone could make a quick $200,000-$500,000 in the span of two years of owning a home, and then pay no tax on the sale, simply by “getting in”.
In my case I was able to get out of the So. Cal. market with some solid advice before the collapse, and now own a home with a very low fixed rate and a payment I can afford, thanks to a decent down payment that came from the gain on the sale.
So ultimately, foreseeing danger wasn’t the issue - it was that most people at the time were willing to risk everything because the chance of success seemed to outweigh the chance of collapse. And in cases like mine and many, many others, it has turned out to be a good gamble. But I do consider myself one of the lucky ones. But there are millions of us in that category who are doing just fine today.
You’re right about the risk being high. I think that it wasn’t adequately priced into the values of the mortgages sold on. And that’s why the declining housing market had wider effects than normal - I wouldn’t expect the US housing market to cause a panic run on a British bank.
And do you know what is even worse? Okay, so now folks can’t borrow on their homes anymore to get quick cash. Now you can get an ATM card associated with your 401k! My God, now the people who do have some kind of retirement…a large percentage of them will do this stupid thing, borrow against their 401k in a VERY EASY way (no more asking for the money and having a good reason and doing tons of paperwork)….it will be gone before they know it…and when the money runs out by the time they retire…I guess the rest of us will be footing the bill for that too somehow…
When will we just STOP and live within our means…this is just going to get worse then…
I’ve heard of this. I think it’s fortunate that in the UK this sort of thing is essentially impossible. Borrowing against your retirement and leaving it unfunded is a recipe for disaster - no one wants to survive only on government handouts in old age..
The sub-prime meltdown is still presenting many difficulties in the market even today. Its slowly creeping its way back to normal but there are a lot of hurdles. The government is helping but is it enough?