US sub-prime woes: Consumption for growth - Views on News from Equitymaster

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US sub-prime woes: Consumption for growth

Aug 1, 2007

A twentieth century phenomena, the United States has been the world beacon in consumer-led economic growth. Even after we entered the new century, the US as well as the other global economies posted great growth - helped by an easy interest rate regime. The Dow and the other Asian and world markets were gurgling up the slope, and the party poopers who saw a fall coming were pooh-poohed. The fly in the ointment was the rather large current account deficit of US$ 856 bn (excess of annual expenditure over income) of the US amounting to 6.5% of GDP. But these worries held no terrors for the world financial circles. More than just the amount of deficit, it is the pattern of financing this excess consumption that is a cause of concern. Families and individuals borrowed against credit cards and other easily available loan schemes. This increased volume of credit at lower interest rates has seen loans being given to ‘uncreditworthy’ families and individuals who would never have been eligible for a loan in the practice of sound and prudential lending.

High-risk borrowers were encouraged, even tempted, to take on loans they could ill afford. In most cases, they were from a socio-economic background that could not comprehend the repayment burden they were taking on. Thanks to the shoddy level of documentation required, some people chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming. More than 80% of mortgages that were securitised in 2006 were low-documentation, stated-income loans, according to Inside Mortgage Finance. That was up from 68% in 2005.

Thus people who could not finance their current consumption even within their expected future incomes borrowed to buy houses from loan sharks at very easy terms, without reading the fine print reserved for a different interest rate regime. This in turn kept the expansion going as new homes meant another boom in the investment cycle.

* The government sponsored enterprises (GSEs) are a group of financial services corporations created by the US Congress. Their function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent. The residential mortgage borrowing segment is by far the largest of the borrowing segments in which the GSEs operate. Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have several trillion dollars of on-balance sheet assets. (Source: Wikipedia)

Mortgage defaults on the rise
Over the last several quarters, the US interest rates were successively raised. The resultant economic slowdown meant that gradually the party started to flag and rates on most of these mortgages were upped sometime in late 2006. And a decelerating income growth in turn reduced the ability to pay interest and amortisation on these sub-prime loans. The US is now gripped by multiplying defaults, and the lenders face non-performing assets whose prices too are falling due to the excess supply of confiscated assets on sale. Fannie Mae estimates that a 5% drop in home prices nationwide leads to a present value loss to them of about US$ 1 bn. In the last quarter of 2006, the Mortgage Bankers Association estimated a total loan default of 5% while that in sub-prime loans was 14.5%. Lehman Brothers estimate in dollar terms, the mortgage defaults could range between US$ 225 m to US$ 300 m going forward into 2008.

What is exacerbating the bad times is that these mortgages reflected very little own equity of the borrower. According to Bank of America Securities, loans to sub-prime borrowers in 2001 covered, on average, 48% of the value of the underlying property. This had risen to 82% by 2006. According to the Financial Times, more than a third of sub-prime loans in 2006 were for the full value of the property.

Snowballing effects
The impact of this US economic sneeze has got magnified as in an effort to cash in on the booming market, the enterprising lenders of sub-prime loans marked them to market and traded them. Most of the world’s well-known financial giants like Bear Sterns, Lehman Brothers and Merrill Lynch created complex derivatives based on these sub-prime loans, which too are marked to market and sold.

In the last few years, European pension fund and Asian institutional investors have entered the fray in buying these mortgage-backed securities, helping to improve the spreads on them. Non-US investors are financing much of the US homeowner at this stage. Thus changes in dollar allocation of various central banks (read China) will clearly flow through as an effect to the US housing market and the impact of any losses on the US sub-prime market will spread globally. The spread of the contagion will be decided by the size of these re-securitised loans and the ability of its buyers to withstand its losses on their books.

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