Lesson 02 / 08
The term Subprime [or Sub-prime]
Mortgages has appeared frequently in the last two years with reference
to the current worldwide economic instability.
What is a Subprime Mortgage and what, if any, is its connection
to the present economic situation ?
Is the affect of
such loans significant and if so how and why ?
What is a Subprime Mortgage ?
A Mortgage is a loan secured by
property, particularly real estate.
The term mortgage is also used to refer to the legal instrument,
which provides proof of, and security for, the loan.
In the event of default it enables the lender to have recourse
against the property.
A Subprime Mortgage is a
mortgage loan made to a borrower whose credit rating does not otherwise
qualify him or her for a conventional loan.
People who have been bankrupt, who have a credit history of late
or missed payments or who have, for whatever reason, no credit history
at all, can have difficulty in obtaining a conventional mortgage.
There is perceived to be a greater risk of default.
Lenders have, at least in recent
years, been prepared to offer such people a variety of borrowing options
in lieu of a conventional mortgage, and which have collectively been
referred to as Subprime Mortgages.
Typically they are short term, high interest, variable rate
loans. Often they include a
short period [2-3 years] of nil or low fixed interest, and then an
interest rate adjustable to market.
How & Why
and declining interest rates and an easy money policy implemented by
the US Federal Reserve 2001- 2003 helped not only to sustain the
stock market but also to create a speculative housing bubble, said
by “The Economist” to be the biggest in history.
1997 and 2006 average house prices in the USA increased 124%.
mortgage lenders originated large numbers of mortgages and then
securitised them, that is to say the mortgages were packaged up and
sold to investment banks and funds throughout the world, at their
nominal face value. Securitisation is a relatively recent invention,
providing an investment vehicle for the cheap easy money the
government had provided. The
lending banks and institutions were thus relieved of primary
responsibility for the ongoing viability of the loan.
Virtually anyone could obtain a housing loan.
The nominal value of securities thus created and sold is said
to have totaled tens of trillions of US dollars, far exceeding the
value of US issued dollar currency.
house prices continued to rise everything was fine.
The securitised packages of US mortgages were marketed as
safe investments paying good returns.
Mortgage borrowers who got into trouble could generally
refinance from eager lenders, or the properties themselves could be
‘flipped’, that is resold at a profit. With relatively few foreclosures, lending banks could
avoid any direct attributable loss to their mortgages by buying the
foreclosed property themselves at a price sufficient to cover
whatever was owed, and thereafter absorbing any loss involved.
ability to package and sell the mortgages at their face value meant
lending banks and brokers tended not to scrutinize carefully the
flipped price on a resale, in order to write the new mortgage, or
even to conspire in accepting an unreal inflated price.
order to curb the ever more apparent excesses a few minor regulatory
changes were made by the government on 7 July 2006 designed to
control flipping. This
led to a small decline in the number of purchasers and is said by
some to have been the trigger for what is referred to as the
property prices began to decline in late 2006.
Foreclosures increased and lenders were unable to disguise
the losses. Increasing
numbers of foreclosures increased the downward pressure on prices
leading to more foreclosures.
foreclosures increased in number the mortgage guarantors were unable
to cope and began to fail. The
value of the securitised mortgage packages became questionable.
fall in property prices coincided with the time when the first of
the Adjustable Rate Mortgages with the 2-3 year low or no interest
payments were about to switch to market interest rates.
Unable to flip or refinance, this further increased the
downward pressure on the market.
and investment houses worldwide were caught holding large amounts of
securitised American mortgages, the value of which, if any, became
ever more questionable. Estimates
of the losses were of hundreds of billions of US dollars, but with
suggestions that they could be much more.
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