The US
The US sub-prime mortgage crisis has lead to plunging property prices, a slowdown in the US
Traditionally,
banks have financed their mortgage lending through the deposits they
receive from their customers. This has limited the amount of mortgage
lending they could do.
In
recent years, banks have moved to a new model where they sell on the
mortgages to the bond markets. This has made it much easier to fund
additional borrowing,
But it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.
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In
the past five years, the private sector has dramatically expanded its
role in the mortgage bond market, which had previously been dominated
by government-sponsored agencies like Freddie Mac.
They
specialised in new types of mortgages, such as sub-prime lending to
borrowers with poor credit histories and weak documentation of income,
who were shunned by the "prime" lenders like Freddie Mac.
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They also included "jumbo" mortgages for properties over Freddie Mac's $417,000 (£202,000) mortgage limit.
The
business proved extremely profitable for the banks, which earned a fee
for each mortgage they sold on. They urged mortgage brokers to sell
more and more of these mortgages.
Now
the mortgage bond market is worth $6 trillion, and is the largest
single part of the whole $27 trillion US bond market, bigger even than
Treasury
bonds.
HOW SUB-PRIME LENDING AFFECTED ONE CITY
CLEVELAND
| Sub-prime lending | Black areas | ||
| Foreclosures (repossessions) | Deutsche Bank properties |
For many years, Cleveland was the sub-prime capital of America
It was a poor, working class city, hit hard by the decline of manufacturing and sharply divided along racial lines.
Mortgage
brokers focused their efforts by selling sub-prime mortgages in working
class black areas where many people had achieved home ownership.
They
told them that they could get cash by refinancing their homes, but
often neglected to properly explain that the new sub-prime mortgages
would "reset" after 2 years at double the interest rate.
The result was a wave of repossessions that blighted neighbourhoods across the city and the inner suburbs.
By late 2007, one in ten homes in Cleveland
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Sub-prime lending had spread from inner-city areas right across America
By
then, one in five mortgages were sub-prime, and they were particularly
popular among recent immigrants trying to buy a home for the first time
in the "hot" housing markets of Southern California, Arizona, Nevada,
and the suburbs of Washington, DC and New York City.
House
prices were high, and it was difficult to become an owner-occupier
without moving to the very edge of the metropolitan area.
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But these mortgages had a much higher rate of repossession than conventional mortgages because they were "balloon" mortgages.
The payments were fixed for two years, and then became variable and much higher.
Consequently, a wave of repossessions is likely to sweep America
And
it is likely that as many as two million families will be evicted from
their homes as their cases make their way through the courts.
The
Bush administration is pushing the industry to renegotiate rather than
repossess where possible, but mortgage companies are being overwhelmed
by a tidal wave of cases.
The
wave of repossessions is having a dramatic effect on house prices,
reversing the housing boom of the last few years and causing the first
national decline
in house prices since the 1930s.
There
is a glut of four million unsold homes that is depressing prices, as
builders have also been forced to lower prices to get rid of unsold
properties.
And
house prices, which are currently declining at an annual rate of 4.5%,
are expected to fall by at least 10% by next year - and more in areas
like California and Florida
HOUSING AND THE ECONOMY
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The
property crash is also affecting the broader economy, with the building
industry expected to cut its output by half, with the loss of between
one and two million jobs.
Many smaller builders will go out of business, and the larger firms are all suffering huge losses.
The building industry makes up 15% of the US
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Economists expect the US
But no one is sure how long the slowdown will last. Many US
CREDIT CRUNCH
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One
reason the economic slowdown could get worse is that banks and other
lenders are cutting back on how much credit they will make available.
They
are rejecting more people who apply for credit cards, insisting on
bigger deposits for house purchase, and looking more closely at
applications for personal loans.
The
mortgage market has been particularly badly affected, with individuals
finding it very difficult to get non-traditional mortgages, both
sub-prime and "jumbo" (over the limit guaranteed by
government-sponsored agencies).
The
banks have been forced to do this by the drying up of the wholesale
bond markets and by the effect of the crisis on their own balance
sheets.
BANK
LOSSES
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The banking industry is facing huge losses as a result of the sub-prime crisis.
Already banks have announced $60bn worth of
losses as many of the mortgage bonds backed by sub-prime mortgages have fallen in value.
The
losses could be much greater, as many banks have concealed their
holdings of sub-prime mortgages in exotic, off-balance sheet
instruments such as "structured investment vehicles" or SIVs.
Although
the banks say they do not own these SIVs, and therefore are not liable
for their losses, they may be forced to cover any bad debts that they
accrue.
BOND MARKET COLLAPSE
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Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds.
These
have fallen sharply in value in the last few months, and are now worth
between 20% and 40% of their original value for most asset classes,
even those considered safe by the
ratings agencies.
If the banks are forced to reveal their losses based on current prices, they will be even bigger.
It
is estimated that ultimately losses suffered by financial institutions
could be between $220bn and $450bn, as the $1 trillion in sub-prime
mortgage bonds is revalued.
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