The Sub Prime Market – What’s It All About?

Sitting in America drinking terrible American coffee I look around and the feel in the air seems to suggest all is not well in America.

Rising unemployment, business confidence (although up, is still down) crumbling infrastructure and services and of course lower house prices.

Why hasn’t or wont Australia follow suit? Or will it?

In this article we are looking at the rise and fall of sub prime market in the US in particular and take a lay-mans view of a lending crisis that is still affecting worldwide lending.

Background

Lenders have been able to offer loans to people who could not prove their credit worthiness since the nineties in the US. These loans, called sub prime loans, are also more expensive to manage by both the lender and the borrower and typically draw in people who can not manage their finances well.

The Situation In The US

They say when America sneezes the rest of the world catches a cold. The housing crisis in the US has seen house prices drop sometimes by up to 50% or more. And even now the housing market appears to be on a long road to recovery with a continuing over supply and easy conditions to walk away from uncontrollable debts.

I even got to go into an American house that reached a valuation of over USD $2m, only to have the owner explain the house was in possession by the bank and now worth less than $1.2m.

The sub prime market (similar to the Australian low doc market) in America has, according to some, been a major contributor to the global financial crisis and the glut in housing leading to a severe drop in house prices and people simply walking away from their homes unable to pay the mortgage.

Names like Fannie Mae and Freddie Mac have become pinacles of over lend under capitalise leading to the demise of many American banks. The rippled effect globally is the increased cost of funds.

Lax Lending Criteria

Talking with Americans they now realise that perhaps the lax lending criteria, coupled with the ease of being able to default and leave a debt, combined to create one of the largest financial collapses of our time. Interestingly in late 2007 only 7% of loans were sub prime but they accounted for 43% of the defaults on mortgages.

The Global Impact

The sub prime crisis had far-reaching consequences around the globe. Tranches of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless.

The sub prime issue was a result of a number of factors including:

• Softening house prices
• High cost of the loans
• People unable to cope with rising interest rates
• Lack of effective government oversight
• Over inflated home appraisals

…to name a few.

As banks began to face widespread defualts – many of the down line borrowers, including some Australian lenders, faced rising costs – fuelling a local raise in interest rates outside of the Australian Reserve.

Could the same happen in Australia?

We dont think so – certainly not to the same extent.

Australia picked up on the low doc lending phenomenon much later in the piece – but we will examine the low doc market in the next article. In the next article we look at the Australian low doc lending market and why we feel Australia is more immune to the lending crsis that has and continues to affect the global housing market.

(data source Wikkipedia)

Written by Jonathan Brake – Marketing Manager Portfolios