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Sub−prime mortgage crisis in United States centre of attention

Mon, Oct 8 2007, 12:09 GMT
by La Caixa Economic Research Dept.

La Caixa

August 2007 will go down in financial history because of the crisis in the US sub-prime mortgage market.What makes up such an asset? How has the «contamination» process worked? Subprime mortgages are mortgages granted to customers of poor solvency and which therefore present greater risk of default than those to «normal» customers. These mortgages are thus qualified when they are granted to persons with a problem credit history or to those unable to provide all the necessary documents (proof of income sources, for example) or in those cases where the amount of the mortgage represents a very high percentage of the price of the home being financed (more than 85%) or the monthly payment represents more than 55% of available earnings, etc. As they are more risky, sub-prime mortgages usually carry a higher interest rate. Normally, customers often pay a differential of between 2% and 3% more than the rate on a standard or prime mortgage.

At this time, the US mortgage market amounts to 10,000 billion dollars, of which sub-prime mortgages represent 13% of the total market and 9% of nominal gross domestic product (GDP) of the United States. A priori, it does not seem that its economic importance should place the liquidity of the US banking system in jeopardy. Nevertheless, two factors have heightened the damaging effects of the increase in default of these assets. Before going into an explanation of this «contamination», however, we should find out who holds these assets in their investment portfolios.

Most of these sub-prime mortgage loans are granted by financial institutions that are not deposit-taking entities and therefore are subject to lower regulatory and supervision requirements compared with those for other banks and deposit institutions. Once the customer uses the loan to buy a house, the debt is noted in the balance sheet of the institution granting the loan. However, in order to boost their business, these institutions relieve themselves of these mortgages and sell them to commercial banks or investment banks.

The new holders, in turn, package the mortgages in blocks and issue securitization bonds (CDO, or Collateralized Debt Obligations) using the sub-prime mortgages as security or collateral. That is to say, based on subprime mortgages, they create a new kind of asset that is more easily negotiable in the markets and it is this bond that carries the risk in the operation. To the extent that the holders of the mortgages keep paying off their debt every month, these funds are used to pay those who have bought these bonds. Those buying CDO are usually investment funds, insurance companies, liquid asset holders, traders, etc. who obtain higher yields from these assets than the market average although, naturally, running greater risk. This new product is broken down according to the credit risk assumed and a qualification or credit rating is assigned by the rating agencies. What credit risk does the buyer of these products take on? It is very simple. The security of the product goes back to the sub-prime mortgage. If a customer fails to pay off a mortgage, the losses shift to the holder of the loan or to the bondholder at the end of the risk chain. Finally, through securitization the sub-prime mortgages have been removed from the liabilities column in the balance sheet of the entity granting the original loan, having been transferred to the institutional customers mentioned above (investment funds, treasury departments of banks, insurance companies, etc.).

If the amount of the sub-prime mortgages represents a small percentage and the risk is spread widely, that is to say, finally distributed among markets operators, how do we explain that the crisis ends up «contaminating» other assets? As we suggested earlier, there have been two key factors, namely, high liquidity and financial leverage. For a number of years, the world financial system has been swimming in a sea of liquidity with a range of resulting factors (expansionist monetary policies, low inflation, development of new technology for managing risk, etc.). In order to correct this situation, the central banks in the main economies moved into a stage of interest rate increases in the face of fear of a speculative bubble linked to real estate assets and raw materials.

A number of factors have come together to bring about the sub-prime mortgage financial crisis in the United States. First, the sharp increase in mortgage interest rates (200 basis points in 2 years).What is more, the real estate sector went into recession in January 2006 with a decrease in the number of housing units sold and a drop in prices. In addition, there was a slight economic slowdown and, finally, an easing of conditions for granting sub-prime mortgage loans, especially in 2005 and 2006. These elements have brought about an increase in mortgage default.

Institutional customers (especially hedge funds), which invested in this type of product, taking advantage of this opportunity for low-cost funding because of their high liquidity, and the possibility of using the carry trade (transactions involving borrowing in low-interest rate currencies offering high return), combined this with high leverage in order to increase yield. That is to say, funds borrowed money using fund assets as collateral in order to increase their investments in the same assets through complex derivatives. They thus heightened the concentration of risk using money from the fund to buy bonds for which the collateral was high-risk mortgages, borrowing in order to buy more bonds of the same type.

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Published on  Mon, Oct 8 2007, 12:13 GMT