What is the Sub-Prime Market - Case Study Example

The Sub-prime Market What is the sub-prime market? The typical profile of a sub-prime borrower is that of someone with a less than ideal credit history. This is availed of mostly by people who otherwise would not get a mortgage from banks and other financial institutions. Usually, borrowers use this credit to: - Purchase homes -In the case of a cash out refinance, finance other forms of spending such as purchasing a car -Paying for living expenses, remodeling a home, or even paying down on a high interest credit card Sub-prime offers borrowers a form of what has been called the “credit repair” wherein if they maintain a good payment history, their credit ratings would be put back into the mainstream and they would be able to borrow like normal customers. Usually there are hidden costs of sub-prime lending that are not visible to the borrowers. The sub-prime market caters to this kind of borrowers. What nations and areas have sub-prime lending? Mostly the sub-prime market is located in the US and most of the borrowers are located there. In addition several of the emerging economies also have had lenders lending to sub-prime borrowers. Investors Who invests in sub-prime? Banks and financial institutions with a high risk appetite invest in the sub-prime market. These institutions take on the risk associated with lending to the category of borrowers who have been classified as risky due to their poor credit ratings. Lenders use a variety of methods to offset this risk. These typically take the form of offsetting the risk with a higher interest rate or various credit enhancements like Private Mortgage Insurance etc. Many of the lenders are affiliates of mainstream lenders operating under different names. What level of return do sub-prime investors typically earn? The rates that sub-prime lenders charge the borrowers depend on the credit history and rating of the borrower. The lower the credit score of the borrower, the higher the rate of interest that is charged by the lender. What form does the investment take? Sub-prime mortgages are brought by financial institutions through a process of origination and securitization. They are brought in the form of bonds and then sold of to normal investors at a rate higher than that for normal corporate bonds. These are typically brought by investors like the hedge funds who have a higher appetite for risk and others who deal in exotic instruments. Where are the investors located? The investors can be located in any of the financial centers of the world like New York, London and Tokyo. Typical investors like Bear Sterns and Citigroup are located across these centers with the maximum exposure happening in New York. Recent Crisis What is the sub-prime crisis? The sub-prime crisis is a manifestation of the foreclosures of mortgages brought by easy access to cheap credit that went bad after the US housing bubble began to burst. An unusually large number of sub-prime mortgages that originated in 2006 went delinquent only months later. The consequent credit deterioration and liquidity crunch was felt across the financial system with the result that Bear Sterns came close to folding up – to be rescued by JP Morgan at the instance of the US Federal reserve. Nearly 50 percent of the sub-prime credit has disappeared or has been acquired at cheap valuations. The foreclosures have been brought about due to the dashed expectations of the borrowers in being able to refinance their mortgages at favorable terms. The sub-prime borrowers are essentially "walking away" from the property and allowing foreclosure, despite the impact to their credit rating. How was it created? The crisis began when a large number of sub-prime borrowers began to default on their mortgages and foreclose the same. The bursting of the US housing bubble led to a large scale crisis the dimensions of which are being felt now. The bubble was created because banks and other financial institutions extended easy credit to borrowers who otherwise would not have got credit due to their poor credit history. These sub-prime borrowers took on mortgages at relatively high rates of interest so that they may avail of the credit that was supplied to them. And the lenders, in anticipation of higher returns took on massive exposures to this category of borrowers. The rising house prices also contributed to the borrowers taking on high risk mortgages in the expectation that they would refinance these borrowings later on more favorable terms. However, housing prices began to bottom out in 2006-’07 leading to refinancing being difficult and hence led to foreclosures by the borrowers. During 2007, almost 1.3 million US housing properties were subject to foreclosure which reflected an increase of nearly 76% over the previous year. What nations are suffering a sub-prime crisis? Any bank or financial institutions that have exposure to the sub-prime market in the US are taking a hit because of the collapse of the sub-prime market. Though, overwhelmingly the sub-prime lenders – the banks and other financial institutions- are based in the US, it is by no means restricted to the lenders in the US. There have been other lenders who have invested in mortgage backed securities caused by origination and securitization of the mortgages. These lenders range from as diverse a pool as Citigroup to ICICI bank in India. How are other nations affected by the sub-prime crisis? What are the advantages of sub-prime lending? The sub-prime crisis has affected the liquidity available in the market owing to the hit taken by the sub-prime lenders due to the record foreclosures as a result of the US housing bubble burst and the consequent crisis of payment. The credit crisis has left no one standing and has affected all the economies that are dependant on the US. Though there has been talk of a “decoupling” of the other economies with the US, there has been an effect felt by most of the emerging economies like China and India. What are the disadvantages of sub-prime lending? The main disadvantage of sub-prime lending is that it is a risky form of lending with the attendant consequences of such a form of lending. What impact has the sub-prime crisis had on other investments in real estate not financed with sub-prime investment capital? Due to the availability of easy credit, housing prices went through the roof in the earlier years of this millennium. This had a cascading effect on other investments as the housing bubble provided ample opportunity for investors to invest and get good rates of return. What impact has the sub-prime crisis had on other investments other than real estate not financed with sub-prime investment capital? The securitization of the mortgages ensured that banks and other financial institutions had lot of exposure to exotic instruments of finance. This led to a boom in the asset backed derivatives with the financial institutions taking a huge exposure to these instruments. Impact on GCC and UAE Is there sub-prime lending in the UAE? There is no sub-prime lending in the UAE. What impact has there been on the GCC and UAE from the sub-prime crisis? The banks and other financial institutions that suffered losses due to Sub-prime crisis in the US and other markets will write down their losses. The Middle Eastern banks that have previously thought that their investments were safe are now realising that some of them may be sub-prime. The consensus view is that majority of the banks do not have “significant” exposure to the sub-prime mortgages and the losses will be minimal. There are others who argue that the UAE is immune from the sub-prime crisis. What all this shows is the true extent of the crisis is not yet apparent and the impact has to be measured over a period of time. As sub-prime mortgages going bad results only after the foreclosures, it cannot be said in advance about the exposure of any particular bank to the sub-prime crisis. Should the UAE have a sub-prime market? From the available literature, it would be better if the UAE did not have a sub-prime market. Sources 1. Arabian News. Sub-prime Crisis to hit Gulf banks’ earnings. 27th January 2008 http://www.arabianbusiness.com/509285-subprime-crisis-to-hit-gulf-banks-earnings 2. Gulf News. UAE immune from sub-prime crisis. 2nd April 2008. http://archive.gulfnews.com/indepth/uaechina/more_stories/10202335.html 3. Economy Watch. Impact of US Sub-prime crisis on Europe http://www.economywatch.com/us-subprime/impact-europe.html 4. McKinsey Quarterly. Handling the sub-prime crisis http://www.mckinseyquarterly.com/Survivingand_prevailingin_the_US_subprime-mortgage_market_2014 5. Mtgprofessor.com http://www.mtgprofessor.com/a%20-%20type%20of%20loan%20provider/what_is_a_sub-prime_lender.htm Read More