The Sub-prime Mortgage Market and Variable Rate Mortgage Market in the USA - Essay Example

Business Report on the Sub-prime Mortgage Market and Variable Rate Mortgage Market in the USA Executive Summary Subprime mortgages are loans extended to those borrowers whose credibility and market standing is questionable. The sub-prime mortgage market is facing serious problems in view of the fact that sub-prime mortgages with adjustable rate mortgages (ARMs) which constitutes almost two-thirds of the total sub-prime mortgage witness serious delinquencies. Such delinquencies have grown to serious proportions. With this manifestation of the problems the sub-prime market is into for some self correction mechanisms. One of the measures taken is the increase sub-prime securitizations to slow down the sub-prime mortgage originations or to fund the growth in the mortgage lending. In this context this report gives a detailed account of the economic impact of the operations of the sub-prime mortgage market and the variable rate mortgage market and the effect of the actions of the lenders in pursuing the securitization vehicle to mitigate the problems being caused by the sharp increase in the delinquencies of the sub-prime mortgages. Table of Contents Executive Summary 1 Table of Contents 2 1.0 Introduction 3 2.0 What is Subprime Mortgage 4 2.1 Different Kinds of Subprime Mortgages: 5 2.2 Variable Rate Mortgages: 6 2.2.1 Basic Features of Variable Rate Mortgage: 7 2.2.2 Initial Rate and Payment: 7 2.2.3 Adjustment Period: 7 2.2.4 The Index: 7 2.2.5 The Margin: 8 2.2.6 Interest Rate Caps: 8 2.2.7 Payment Caps: 9 2.2.8 Prepayment Penalties: 9 3.0 Impact of the Increased Delinquencies on the US Financial Market 9 4.0 Process of Securitisation: 11 5.0 Conclusion: 12 References 13 1.0 Introduction The US economy is greatly affected by the delinquencies in sub-prime mortgage loans and the number of foreclosures in the home loan market giving rise to the need for serious economic, social and regulatory measures. The credit needs of the low income individuals are often met with 'predatory lending' which comprises of a number of financial practices. This kind of lending has become increasingly predominant in the rural areas. The forms predatory lending usually takes the form of payday loans check cashing and car title loans which threaten the income and assets of the borrowers by the higher rate of interest and stringent repayment conditions. The subprime mortgage market can be considered as an extension of this lending practice prevalent in the housing market. Subprime mortgage loans carry interest rates much higher than the prime loans in order to cover the additional risk exposure of the lenders in extending credit to the borrowers who are considered to have a bad loan track and defaulters in repayments. With the increase in the subprime lending the rate of failures has also considerably increased, as most of the loans have been granted to those who did not have the adequate means to repay the loans. When such failures have reached a greater proportion, "Investors have started scrutinizing subprime loans more carefully and, in turn, lenders have tightened underwriting standard". Certain other measures including credit spreads over subprime securitizations have also been undertaken to control the rate of delinquencies. Different aspects of the subprime mortgage including the variable rate mortgage are discussed in the following sections of the report. The report also details the process of securitization being adopted by the mortgage originators to fund the growth in their mortgage lending. 2.0 What is Subprime Mortgage Although the term 'subprime mortgage' is used to indicate the loans offered to those borrowers whose credibility is doubtful, the term "subprime' does not signify the character of the loan itself but characterizes the borrower meaning the borrower has a substandard credit status. Lack of good credit history and habitual defaults in repayments make the borrowers to get into the status of sub prime borrowers. Subprime lending can take a variety of instruments like subprime mortgages, car loans and credit cards. The expansion in the sub-prime mortgage has made the home-ownership possible for those borrowers who otherwise would not be able to qualify for any borrowing. There has been a sharp increase in the subprime mortgage in the recent years. "In 1996, subprime lenders reported $90 billion in lending. By 2004, the subprime mortgage market had grown to $401 billion." (Carsey Institute, 2006) "Last year, 13.5 percent of mortgages originated in the U.S. were subprime, according to the Mortgage Bankers Association, compared to 2.6 percent in 2000. Overall, the subprime market was $600 billion in 2006, 20 percent of the $3 trillion mortgage market, according to Inside Mortgage Finance. In 2001, subprime loans made ups just 5.6 percent of mortgage dollars" Ellen Florian Kratz (2007) "For these mortgages, the rate of serious delinquencies - corresponding to mortgages in foreclosure or with payments ninety days or more overdue - rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005" (Ben S. Bernanke, 2007) With the increase in the subprime mortgage market, the concerns over the adverse effects of the predatory loans have also increased. Indirectly forcing borrowers to take loans with very higher rates of interest and processing and other fees than they could really eligible and afford is one of the components of predatory lending that is being often adopted by the lenders. "It has been estimated that as many as half of all subprime loan borrowers could in fact qualify for conventional rate mortgages" (Fannie Mae and Freddie Mac, 2004) According to the U.S. Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment delinquencies and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.". 2.1 Different Kinds of Subprime Mortgages: The originators of subprime mortgages operate by adopting different forms of mortgage loans. Some of them are: 'Pick a Payment' loans under which the borrower has the option to decide on their monthly commitments for repayments. The borrowers may choose between full payment, only the interest, or a minimum amount. Fixed rate mortgages or variable rate mortgages Interest payments only schemes where the borrower would be paying only interest for the initial periods of the loan Variable rate mortgages have been the popular method of subprime mortgage among the lenders for over two decades. 2.2 Variable Rate Mortgages: Variable rate mortgage is a type of mortgage program in which the interest rates and payments against the mortgage are adjusted very frequently. The frequency of adjustments may even be on every month. For the 'fixed rate mortgage' loans the interest rate on which the borrower takes the loan is decided at the time of getting the loan and there will be no change in the interest rates thereafter. The variable rate mortgage is also known as 'Adjustable Rate Mortgage' (ARM) or 'Adjustable Mortgage Loan'. "An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly" (The Federal Reserve Board) In the case of ARM the lenders generally adopt a lower rate of interest initially than what they charge for fixed rate mortgages. For the same amount of loan the ARM may work out easier than the fixed rate loans initially. Moreover when the interest rates remain same or become lower over the period, the ARM will work out cheaper than the fixed rates for the borrowers in the long run. However on the contrary when there is an increase in the interest rates the ARM may lead to higher monthly payments which have happened in the US home loan market recently. The increase in the interest rates is the risk the borrower has to take in cases of ARM. 2.2.1 Basic Features of Variable Rate Mortgage: This section of the report details the basic features of the variable rate mortgages or adjustable rate mortgages (ARM) 2.2.2 Initial Rate and Payment: The initial rate of interest and the payments against the mortgage will be kept in force for a limited period of time. This initial period may range from as short as one month up to a period of five years. It is quite possible that the interest rates and monthly payments may be totally different in the long term from the initial payments and rates. Usually they will be changed to a large extent even if the interest rats do not vary too much. Hence it is advisable that the borrower asks for the Annual Percentage Rate (APR) at the time when he gets the quote from the lender for the initial rate and payments on the loan if the borrower chooses to adopt ARM. If the APR is quoted at very high rates than the initial rates then it is quite evident that the future rates and payments would be very much higher when the adjustments of the rates start at a future date. This will be the case even if there is no change in the interest rates. 2.2.3 Adjustment Period: "With most ARMs, the interest rate and monthly payment change every month, quarter, year, 3 years, or 5 years. The period between rate changes is called the adjustment period." (The Federal Reserve Board) For example, a variable rate mortgage where the rate changes once in a year is called a 1-year ARM; and in a 3 year ARM the interest rate and payment will change over a 3-year adjustment period. 2.2.4 The Index: The interest rate in a variable rate mortgage consists of an index and the margin. The 'index' is a general measure of the interest rates and the margin represents an additional amount that the lender adds to the payment. When the index rate goes up it has its impact on the interest rates and consequently the borrower has to pay higher amounts every month. Conversely if the index rates go down the borrower would be benefited by making lesser monthly payments. 2.2.5 The Margin: "To determine the interest rate on an ARM, lenders add a few percentage points to the index rate, called the margin. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan" (The Federal Reserve Board) A 'fully indexed rate' represents the rate equal to the margin added to the index. A rate is called a 'discounted index rate' when the initial rate on the loan is lesser than the fully indexed rate. It is also possible that a lesser margin may be added by the lender where the credit status of the borrower is good. In that case the borrower would be paying a lower rate of interest. On any comparisons of different ARM both the margin and the index rates need to be looked in to. 2.2.6 Interest Rate Caps: By placing a limit on the interest rates it is possible for the borrower to restrict the increase in the amount of the interest. This limit is known as 'interest-rate cap'. The interest rate cap can take the following forms: Periodic Adjustment Caps: The periodic adjustment caps have the effect of limiting the amount of the interest rate up or down from one adjustment period to the next after the first adjustment. Lifetime Caps: The lifetime caps are applied to the interest rate changes over the life time of the loan. Legally all the ARMs are supposed to be influenced by lifetime caps. 2.2.7 Payment Caps: In addition to the interest caps the borrower also has the option of specifying the monthly payment limit which is known as 'payment cap'. With the payment cap in place the monthly payments by the borrower can not exceed the limit fixed for the payment. There are loans which have only payment caps but nor periodic interest caps. 2.2.8 Prepayment Penalties: One important aspect that the borrower should be careful about is the prepayment penalties as in some cases the prepayment penalties may not even allow the loan to be closed. A prepayment penalty is levied by the lender in the case of some ARMs including interest only and payment option mortgages, if the borrower wants to refinance the mortgage or settle the ARM earlier than the mortgage period. There are 'hard prepayment penalties' implying the payment of penalties for the closure of the loans for whatever reasons. The 'soft prepayment penalties' demand the payment of a penalty only when there is the case of the refinance and the buyer will not be required to pay any penalty if the borrower sells the home. 3.0 Impact of the Increased Delinquencies on the US Financial Market The delinquencies in the subprime mortgage market have lead to a sharp increase in the foreclosures of home loans from the beginning of 2006. The financial crisis created by the home loan market in the US has spread to the whole of the world during the second quarter of 2007. The increase in the interest rates has increased the adjustable rate mortgages. There was a sharp decline in the values of house properties marking the end of the housing bubble in the US. This has created the effect of leaving the house owners having no means to settle the outstanding home loan installments. The lenders were also deprived of any chances to recoup the monies advanced. The increased foreclosures have made major subprime mortgage lenders either close down their operations or file bankruptcy petitions. The stock prices of several large subprime mortgage companies have been dropped to a great extent. "In London, the FTSE index lost 250 points and closed below 6,000 for the first time since last autumn. This followed a big stocks sell-off in Asia, which in turn was prompted by a warning from investment bank Merrill Lynch that the U.S. mortgage lender Countrywide could go bust as a result of the crisis in the American housing market." Larry Elliott (2007) This had its effect on the other stock markets globally making several hedge funds tumbling down. The effect of this meltdown has affected the global financial market forcing large foreign and domestic hedge funds to reevaluate the risks associated with their various dealings and assets. The other effects are that there will be reduced consumer spending and the equity and the derivative markets worldwide will be experiencing high volatility. The effect of the housing market crisis thus has snowballed which could lead to an economic slowdown globally and may even result in a possible recession. The reason for this state of affairs is the failure on the part of the investment banks to reveal the weak base on which the mortgage securities business was built up. The investment analysts were filing routine reports cautioning a possible melt down which was given the treatment as a weather report. There was sluggishness on the part of the credit rating agencies and they were not swift enough to reclassify these kinds of weak securities. "Finally, as Nouriel Roubini, economics professor at New York University puts it; there is a difference between crises of liquidity and crises of insolvency. Liquidity crises are those in which firms and individuals have a cash flow problem; interest rate cuts help them through the tough times. Insolvency crises are much more serious; slashing rates makes no difference when people are going bust." .Larry Elliott (2007) what has happened in the case of subprime market now is an insolvency crisis. 4.0 Process of Securitisation: "The Mortgage Bankers Association has reportedly estimated aggregate housing loan default at around 5 per cent of the total in the last quarter of 2006, and defaults on high-risk sub-prime loans at as much as 14.5 per cent." With this high delinquency rates the total mortgage defaults have been estimated to be in the order of $ 225 billion and $ 300 billion during the years 2007/2008. The crisis has badly affected the mortgage lending firms who have borrowed excessively to finance the lending. However with the increased awareness of the potential risks associated with the subprime mortgages the lending firms resorted to the process of securitising the mortgages to cover their exposure. With this kind of securitisation the mortgage lenders and brokers were able to sell off their mortgages to other banks and financial institutions like the investment bankers and still were able to make a profit. "Firms such as Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, Deutsche Bank, UBS and others bought into mortgages, pooled them, packaged them into securities and sold them for huge fees and commissions." (Chandrasekhar and Jayati Ghosh, 2007) "In fact, the process of securitisation involves many layers. To quote the Financial Times, the original mortgages are "sold by specialist mortgage lenders on to new investors, such as Wall Street banks, who then use these to issue bonds which are often then repackaged as derivatives." According to that paper, data from the Securities Industry and Financial Markets Association indicate that more than $2 trillion of mortgage-backed bonds were sold last year, of which about a quarter were linked to sub-prime mortgages. In sum, this whole process, which has at the bottom home-owners faced with foreclosure, is driven by layers of financial interests looking for quick profits or high returns. This has transformed the mortgage securities business. In earlier times, these securities were bought by investors who held them till the loans matured and earned their returns over time. Now these are marked to market and traded. They are also used to create complex derivatives, which too are marked to market and traded." (Chandrasekhar and Jayati Ghosh, 2007) 5.0 Conclusion: The increased delinquencies have caused ripples in the American Economy and to some extent the collapse of the real estate bubble was predicted by the economists. However the economy has to face the brunt of this collapse with a pile of housing inventories. In addition difficulties are being experiences in the sale of existing homes. The housing bubble caused mostly by the subprime mortgages has induced the average Americans to live beyond their means. Economically this had a devastating effect in that there have been a negative growth in the net savings during the past few years which has severely hit the growth of the economy. It is sure that the American economy will be compelled to slow down at least for quite a few years in the near future. References Ben S. Bernanke (2007) 'The Subprime Mortgage Market' (Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and Competition, Chicago, 17 May 2007). http://www.bis.org/review/r070522a.pdf Carsey Institute (2006) 'Subprime and Predatory Lending in Rural America: Mortgage lending practices that can trap low-income rural people' Policy Brief No 4 Fall 2006 http://carseyinstitute.unh.edu/documents/PredLending.pdf Chandrasekhar and Jayati Ghosh, (2007) 'Lessons from the US Sub-prime Lending Crisis' The Business Line Newspaper dated 17th April 2007 http://www.thehindubusinessline.com/2007/04/17/stories/2007041700380900.htm Ellen Florian Kratz (2007) 'The Risk in Subprime' Fortune Article CNN Money.com http://money.cnn.com/2007/02/28/magazines/fortune/subprime.fortune/index.htm Fannie Mae and Freddie Mac. 2004. Separate and Unequal Predatory Lending in America. ACORN: Washington, DC Larry Elliott (2007) ' This is not just a market wobble' Opinion The Hindu Newspaper dat 18th August 2007 http://www.hindu.com/2007/08/18/stories/2007081856201100.htm The Federal Reserve Board 'Consumer Handbook on Adjustable-Rate Mortgages' http://www.federalreserve.gov/pubs/arms/arms_english.htm Read More