The US Sub-prime crisis – Why Australia?
Extract of an article by: Ange Montalto, Senior Economist, Financial System Analysis – ANZ Economics, explains.
“So what is a sub-prime loan? Essentially, it is a loan
made to borrowers with impaired credit histories, poor financials and probably
not so reliable incomes – they’re more likely to struggle with
loan servicing than others, particularly if circumstances turn against them.
Sub-prime mortgages in the US lifted from around 3% of all mortgage loans
in 2000 to around 15% in 2007. Why did this happen? A strong US economy and
rising house prices prompted lenders to chase market share. They did this
by relaxing loan criteria (e.g. higher LVRs (loan to valuation ratios), providing
approval on inadequate or no income verification). Assessments by lenders
of loan affordability were increasingly measured on “honeymoon”
or discounted rates. The reset, typically a couple of years later, inflicted
a lot of hurt, particularly with market rates rising during the “honeymoon”
period.
As the interest rate cycle peaked, borrowers defaulted and house prices started
falling. By December 2007, 17.6% of all sub-prime mortgage loans were delinquent.
Estimates of Australia’s sub-prime market, size it at around 1-2% of
total mortgage loans, so even if there were evidence of similar stress levels
within that sector in Australia, the implications would be much less significant.
So who gets hurt?
Even though we don’t have a sub-prime crisis in Australia, the turmoil
is feeding through to Australia through various channels.
The US borrower is the first casualty – the financial stress of higher
servicing costs and ultimately, default will in many cases result in losing
the roof over one’s head. The next to get hurt depends on what happened
to the loan after it was written.
In a simple banking model where deposits are raised and then on lent to home
borrowers, the losses can be isolated to who is doing the lending. If the
losses are big enough, the capital of that institution can be wiped out –
shareholders bear the risk in this instance. The bulk of Australia’s
mortgage loans remain on the balance sheets of Australia’s deposit-taking
institutions, mainly banks – and these are generally of a high quality.
In the US and increasingly in Australia, the mortgage loan market has operated
using a parallel model, whereby loans originated by either banks, brokers
or others lenders are packaged to create a portfolio that is converted to
securities (securitisation). These securities are sold to investors, ranging
from superannuation funds, local councils, charities etc. Interest and principle
from the home loans flow through to the investors that buy the securities.
The mortgages are held as collateral. If borrowers default and house prices
fall enough, the holders of those securities lose out.
Mortgage Insurance: (generally by ‘monoline’
insurers) has served to ‘enhance’ the quality of these investments
by guaranteeing principle and interest payments to a specified limit. This
made investors feel safe. But with ratings agencies earning handsome fees
from those actually structuring the securitisation programs – it was
in their interest to provide the “appropriate blessing”, sell
it off to say a local council or superannuation fund and move on to the next
issue; the agencies and insurers were distracted by the momentum of fee income.
Given the extent of loan defaults, no amount of insurance would have safeguarded
the value of these securities. Insurers are suffering under the weight of
claims with some going bankrupt.
The confidence effects from this experience have rippled out to most other
kinds of securities – asset-backed securities, corporate bonds, and
bank bills - even though the underlying assets or companies raising the funds
remain sound. There is a gaping hole between the return investors require
and what borrowers are used to paying.
Activity in our own securitisation market and other debt markets has fallen
sharply in recent months as issuers and investors remain wary, making it difficult
for those that rely on this funding to do business (e.g. non-bank originators).
Banks, which fund a large chunk of their lending using borrowed funds (from
overseas), also are having to pay considerably more for these as well as for
deposits raised from the household sector. Some of this extra cost is passed
on to borrowers (both home, personal and business) in the form of higher lending
rates while some is borne by shareholders – witness the fall in most
banks’ share prices in recent months! The crisis has also presented
a double-edged sword for banks: On the one hand, as the funding channels for
non-bank lenders dries up, banks are increasing their market share of the
lending market (re-intermediation). This boost to the asset side however,
has coincided with pressure on the deposit or borrowing side of the balance
sheet, intensifying the importance of liquidity management.
A settling in market conditions will see liquidity return. Getting there,
however, will require a re-calibration of interest rates across and within
debt markets that better reflect a more realistic assessment of underlying
risk. Insurers and rating agencies need to restore their credibility in the
market place, and investors need to restore their confidence in sound financial
structures, discriminating between good credits and not so good credits. How
long this will take is the most difficult call to make but it is likely there
will be ongoing pain for some as the mess sorts itself out.”