Sub-Prime Lending - Assignment Example

Introduction Getting consumer credit through various financial s especially banks requires consumers to maintain a certain degree of credit rating in order to qualify for those loans. Unlike large corporate companies, consumers or rather individuals pose a different challenge and dynamics to financial institutions to cater their needs for credit and formal funding requirements of these individuals. It is because of this reason that various banks and financial institutions have developed their internal rating methodologies which they assign to various consumers asking for credit. Banks than through their internal as well external credit scores or ratings decide to whom they should provide the credit. These criteria of credit rating often are designed to be tough since Banks in order to avoid defaults, tighten their criteria to extend the credit to these customers. However, due to increasing needs of those customers, whose credit history or their credit ratings do not fall under the criteria laid down by the banks, banks try to accommodate them also. Sub-prime lending is the part of that phenomenon. What is Sub-Prime Lending? “Sub-Prime lending typically has been characterized as lending at relatively costly interest rates and fees to credit impaired or otherwise high risk borrowers.” (Lax, Manti, Raca, & Zorn, 2004). Subprime loans are among the newly popular mortgage products, such as interest-only loans, for people with strained budgets, including first-time buyers. Homeowners increasingly use them to refinance and consolidate household debts when their credit scores fall in the wake of bankruptcy, high medical bills, or other setbacks. (Blanton, 2005). It is generally believed that the subprime borrowers emerge due to lack of the good credit history on their back and since there number grew historically therefore banks and financial institutions by spotting the opportunity started lending to them at higher interest rates due to the perceived risks involved in the due to the perceived risks involved in these subprime loans. Not only these subprime borrowers pay higher interest rates but they also pay higher upfront fees also at the time of booking their loans. Due to this profitable alterative, financial institutions take the risk and lend to those customers who would otherwise can not qualify for obtaining loans from the banking channels in the ordinary course of the business. In nutshell, we can say that subprime lending is lending to those who do not deserve it. Why Sub-Prime Lending Crisis happened A subprime lender generally lends following types of loans and it is because of these loan structures that subprime mortgage crises emerged. Interest Only Loans are the loans which give borrower an option to pay interest on their loans only; thereby Principal remain unchanged and at the end of loan term payments increase substantially. Traditionally these loans are cheaper in nature as the normal mortgage loans require some portion of principal and mark-up to be paid in the monthly installment of the mortgage. These loans became popular mainly due to the fact that they required lower loan payments therefore buyers can afford the larger homes as their monthly mortgage bills become lower as compared to other standardized mortgage loans. These loans however can be dangerous especially when markets are lower and down. Since the interest rates are fixed for very short period of time i.e. 1 to 5 years therefore as the re-pricing of these loans approach, any increase in the interest rates will suddenly increase the interest repayments. This will result in loans being converted into conventional mortgage loans which eventually force the borrowers to face new and tougher requirements to meet besides paying the principal repayments. (Amadeo,). Negative Amortization arises when an investor pays the amount less than the accrued interest and the interest is added back to the loan balance. Normally amortization means the reduction of the loan balance as under the conventional mortgages, a buyer’s payment to the financial institution comprises of two parts i.e. principal as well as mark-up. The negative amortization is usually availed by the buyers in order to reduce the payments at the start of the mortgage. Within the perspective of subprime loans, negative amortization works fine for the buyers with low income or bad credit history thus enabling them to pay less and still enjoy the home mortgage. The negative amortization therefore has been used both for fixed rate loans and adjustable rate loans. With reference to the adjustable rate loans, negative amortization also works to safeguard the buyer from the large interest rate shocks as the increase in the interest rates may force them to pay higher than their normal interest payments. The downside of negative amortization is that the payment must be increased later in the life of the mortgage. The larger the amount of negative amortization and the longer the period over which it occurs, the larger the increase in the payment that will be needed later on to fully amortize the loan. The biggest risk in this kind of loan arises when the buyer is going to sell his home. “If theyve lived in it for several years while paying on a negative amortization loan, its possible that the loan amount has become larger than the amount that they can actually sell the house for. In other words, when they go to sell the house, not only will they not gain any profit, but theyll actually owe money to the bank. So if a homeowner doesnt fully understand the long-term consequences of a negative amortization mortgage, it can lead to severe and unexpected financial difficulty with negative effects on your credit-even foreclosure or bankruptcy.” (Mortgage News Daily) When we talk about the negative amortization on the fixed rate loans, the risk of increase in the mortgage payments in the future increases and the instrument under which this is guaranteed is called Guaranteed Payment Mortgages or GPM. Subprime lending become more complicated when buyers in anticipation that the home prices will increase therefore they pay low rates in order to gain advantage of the price increase in equity to refinance. However this has not been the phenomenon mainly due to following two reasons: 1. Minimum payment options increased principal balance. In anticipation of the increase in equity, buyers paid low interest payments which subsequently contributed towards the increase in their principal payments when loans were about to mature or when the refinance option was to be availed. This significantly reduced the spread between the equity gain and the principal outstanding in the loan thus effectively reduced the perceived benefits for the buyers to refinance at the later stages of the finance. 2. Home values have potentially depreciated against the perception of the market and the consumers. What was perceived that the home prices will increase in the future does not prove right therefore further reducing the equity of the buyers. Further the refinance standards were tightened by the lenders therefore with diminishing equity values and tightening refinance standards, the buyers found themselves trapped to pay the higher interest payments with virtually nothing to gain. This has therefore complicated the market and the buyers started to default on their repayments thus creating a crisis in the real estate market. Probably the second most important reason behind the crisis in the real estate market is the fact that the appraisers tend to increase the value of the homes. Since the loosened monetary policy allowed the reduction in the interest rates and there were excess liquidity present in the market therefore lenders in order to grow their business started to lend with loose credit term to accommodate as many customers as they want. Since the economy was facing a boom therefore the home prices were inflated too. lenders offered overpriced loans since the appraisals made were on the higher side therefore in order to take benefit of the higher real estate values, the lenders ignore the risks involved in the process and offered overpriced loans. Since appraisals were overpriced therefore lenders disbursed more than the required amount for the mortgage loans thus effectively draining the resources in potentially threatening and risky business options. Besides inflated priced collaterals were sold as securitized securities by linking the cash flows from the mortgages with the securitized securities therefore technically recouping the lost liquidity made through mortgage loans. Brokers and agents made larger commissions as the higher values entitled them to get higher commissions and better incentives. This has worked in two ways. Through appreciating the values of the homes, lenders not only get the psychological benefit that in the event of foreclosures, the bank can recoup their investment by selling them. Thus the inflated market prices on one hand not only provided the necessary psychological comforts to the lenders but also provided the large commissions to the brokers and agents for booking the new loans. The inflated prices of the homes caused the homeowners to avail higher financing which were higher than the actual value of their homes therefore when they went to sell their homes, the prices they fetched were significantly lower than the their loan amount. Since the values of the homes were significantly lower than the loan amounts of the buyers therefore there was no significant increase in the equity of the buyers hence there were not being eligible to refinance their home mortgages when their payments finally increased due to the start of the principal repayments of the loans. 3. The up side down on the mortgage occurs when the buyers owe more than the value of the mortgaged home. Since in the beginning of the mortgages, the buyers prefer to interest only loans therefore when the time to repay arrive, given the inflated appraisals and prices, the homeowners find themselves trapped. Since one hand cannot sell the homes to get inflated equity and secondly they owe more than the worth of the homes this combined with the financial hardships force buyers to short sell their homes. They short sale their homes as they owe more than the value of their homes and lenders in order to decrease their losses, allow the short sales of these homes thus a vicious circle tend to complete where homes bought with great expectations are sold out in desperate conditions. Since buyers short sell their homes with the help of the lenders therefore from the lenders perspective, short selling of the homes create a lesser impact on the credit history of the buyer than the outright foreclosure. It is because of this fact that lenders somehow manage to recoup some of their investments in the end therefore short sale remains a very viable option to both lenders and the buyers. However these short sales under the distressed conditions are sold at less than their values therefore they place a negative impact on the prices in the existing market because they are one of the strongest signals to determine the value in the market. Besides short selling of the homes create other non-financial costs for the area as the new and potential buyers view the area with more suspicion and take time to decide on making their purchase of the home to be acquired through short selling and under financial distressed condition. Global Impacts One of the strongest reasons behind the sub-prime mortgage crisis is the financial innovation. Lenders in order to recoup their lost liquidity into the sub-prime mortgages started securiting their exposures in subprime mortgage market and tied the cash flows of the mortgage backed securities with the cash flows to be generated from those securities. However when the crisis hit and customers started to default on their mortgage payments, those lenders started to make payments out of their resources thus creating strong credit crunch in the market and the resources which could have been put into the productive use were being paid into liquidating the bond repayments. This has resulted into the weakening of the economy, increasing interest rates and resultantly increases pressures on the currency to depreciate. Increased interest rates not only pushed the bond prices down, they also made the borrowing more costly hence legitimate borrowers found it difficult to borrow at reasonable rates. This increase in the borrowing cost would again result into the lost productivity as well as increased prices due to cost pull inflation as the input prices tend to increase due to the expensive borrowing. With the advent of mortgage crisis in the world, Australian Financial Markets are also being hit as the second hedge fund in Australia has been affected by it also. The boutique company Absolute Capital has suspended its two funds worth around $200 million mainly due to its exposure to the risky mortgage. The Basis Capital also earlier declared to its investors that their investment into the fund is in jeopardy. (Ryan, 2007). Apart from hitting the Australian Market, the worst hit US markets are continuously being witnessing the decline and increase into foreclosure. Though many believe that due to smaller size of the market, the impact may not be worse however current evidence and steps taken by the Federal Reserve Bank suggest that the crisis are not yet over and that they have more threatening consequences. Further due to weakening dollar due to economic slow down, the inflation has been on increase in the Australia and the new government is trying to contain the inflation first which has mainly been emerged due to the subprime mortgage crisis in Australia. (Cary, 2008). In its recent report, IMF has warned that Global mortgage crisis could hit AUS $ 1 Trillion with fears that the crisis would spread over the other financial markets of the world including Australia. (World News Australia, 2008). With reference to the foreclosures, there are also reports which suggest that due to increase in the foreclosures, there are some social disadvantages also as those who are getting affected by the crisis are poor, minorities and low income strata of the society which is already underprivileged and deprived. (Bonner, 2007). However on the other side there are also reports which suggest that due to changed lending rules in Australia, the crisis may not hit with the same intensity to the financial institutions of Australia. The so called No doc and Low doc loans offered in Australia are not particularly being categorized as subprime. Though Australian financial institutions do accommodate the sub-prime customers but they only account for 2% of the total market in Australia. (Yardney, 2007) Conclusion Sub prime mortgage crisis are on putting the various economies of the world into vicious circle where most advanced economies of the world are facing the problems to lessen its impacts. What started into US has now spread into other countries also including Australia as financial institutions into the country are feeling the heat of the crisis. The increased foreclosures and increase in the risk of investing into mortgages have resulted into the suspension of various hedge funds into Australia besides showing other impacts on different sectors in the economy. However there are positive news regarding Australia also as the overall market size of Subprime in Australia is just 2% of the total market. Works Cited Blanton, B. K. (2005, August 3). Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate. Retrieved Jan 19, 2008, from boston.com: http://boston.com/business/personalfinance/articles/2005/08/03/dark_side_of_subprime_loans/ Bonner, B. (2007, June 21). Foreclosures Rise As Subprime Mortgage Crisis Hits Minorities, Poor. Retrieved April 10, 2008, from The Daily Reckoning Australia: http://www.dailyreckoning.com.au/foreclosures-rise/2007/06/21/ Cary, G. (2008, Jan 10). Interview with Greg Cary:US sub-prime mortgage crisis, inflation, mortgage rates. Retrieved April 11, 2008, from Treasurer of the Commonwealth of Australia: http://ministers.treasury.gov.au/DisplayDocs.aspx?doc=transcripts/2008/006.htm&pageID=004&min=wms&Year=&DocType= Lax, H., Manti, M., Raca, P., & Zorn, P. (2004). Subprime Lending: An investigation of Economic Efficiency. Housing Policy Debates , 15 (3), 533-571. Ryan, P. (2007). US subprime mortgage crisis hits Aust funds. Retrieved April 10, 2008, from ABC News: http://www.abc.net.au/news/stories/2007/07/26/1988601.htm World News Australia. (2008, April 09). US mortgage crisis could cost $1 trillion. Retrieved April 11, 2008, from http://news.sbs.com.au/worldnewsaustralia/us_mortgage_crisis_could_cost_1_trillion_544567 Yardney, M. (2007, September). What does the American Sub Prime Mortgage Crisis Mean for Australia. Retrieved April 10, 2008, from Real Estate : http://www.realestate.com.au/review/sep072/america-sub-prime.html Read More