plonkee money

January 31, 2008

American sub-prime crisis: should the rest of us care?

Filed under: banking and economics — Tags: , , , , , — plonkee @ 12:00 pm

lego townThis 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:

  1. A sizeable deposit
  2. A verified income
  3. A house in mind, in fit condition
  4. 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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