Overview of the US subprime market Essay Example for Free

Overview of the US subprime market Essay With regards to the U. S. subprime market, the term itself refers to the status of the borrower, alternative terms for which are B-paper, near-prime, or second chance lending, all refer to the practice of giving loans to borrowers who have a faulty credit history and hence do not qualify for the prevalent market rates. Subprime lending and borrowing is risky as it is associated with conditions of high interest rates, dodgy credit history and much less-than-perfect financial situations. To gain access to this expanding market, lenders often assume risks associated with lending to people with poor credit ratings. They offset their risk by charging a higher interest rate, among other ways. Mortgages, car loans, credit cards, all are instruments of subprime lending. In credit cards, for example, a subprime customer may be charged higher amounts for late fees, over limit fees, annual fees, or up front fees for the card. But it offers these borrowers who have an imperfect credit record the opportunity to gain access to credit which might not have been possible otherwise. Subprime Credit Crunch and Mortgage Crisis: Since 2006, however, a severe financial crisis has developed in the subprime credit market. It is especially rampant in the subprime mortgage market which has experienced an increasing rate of foreclosures. When Interest rates rose, this led to adjustable-rate mortgages becoming more popular. But the housing bubble did not last and property values plummeted, borrowers could not fulfill their financial commitments and lenders could not recover their losses. The result is today’s harsh credit crunch which has led to big players in the subprime mortgage lending industry to shut down or file for bankruptcy. Others have been accused of encouraging deceptive income inflation on loan applications. Between December 2006 and March 2007, more than 30 subprime lenders closed operations. The rest have incurred serious losses and are in grave financial trouble. Lending standards have become more stringent and economists at Goldman Sachs have predicted this to cut annual demand for new homes to go down by one-fifth of last year’s sales. According to the September quarterly report (2007) of the Bank for International Settlements (BIS) in Basil, Switzerland, BIS warned of the `dark shadow over global financial markets caused by the collapse of the US subprime market. ` Analysis: It all started as a small setback in December 2006 but has quickly made its way all over the world, and by the summer of 2007 had had a substantial negative impact on stock and bond markets of the world. Investors have suffered heavy losses in their portfolios and now face the additional threat of a possible global recession in the near future. World economic growth is significantly tied to U. S. growth, and as analysts predict a recession in the near future, U. S. Subprime mortgages can be perceived as one of the main catalysts of the current situation. A global financial turmoil has ensued, which has made its presence felt in all corners of the world, as numerous hedge funds, banks and stock markets in remote countries such as Australia, Thailand and Germany have even felt the brunt. This has resulted in a backlash against some financial strategies employed by investors as countries were taken aback by the impact of the problems of American mortgagors and homeowners on their home markets. Funds and banks all over the world were affected because they had earlier bought either bonds, or risks related to bonds, which had bad home loans as collateral, and this entire bundle was known as a C.  D. O. or a collateralized debt obligation. JPMorgan estimates showed that global C. D. O. s accounted for about $1. 5 trillion of debt and structured-finance C. D. O. ’s, which refers to bonds which have subprime mortgages, slightly safer mortgages and commercial mortgages as collateral, accounted for about debt of $500 billion to $600 billion. When these subprime mortgages were hit badly, it led to a chain effect in an imperfect system, with ratings which did not provide an accurate prediction of risk and flawed assumptions about the impact on diversified portfolios with multiple layers of leverage. A ripple effect ensued all over the world as investors started freeing themselves of any risky investments and converting their securities into cash. As Pierre Cailleteau, Moody’s Investors Service chief economist in London said, The combination of a subprime shock, â€Å"untested financial innovation and leverage has led to a confidence crisis. Impact on Financial Markets: Financial markets have been badly affected, as financial institutions on Wall Street and all around the world attempt to cope with the disastrous state of affairs in the U. S. subprime market. In June 2007, according to a report by CNNMoney, assets worth $800 million were seized by Merrill Lynch from two hedge funds being managed by Bear Stearns, one of the largest financial institutions of the world, that were dealing with securities, mainly bonds backed by subprime loans. These troubled funds have almost worthless now. Merrill Lynch itself reported in October 2007 losses of US$5. 2 billion, revised in the same month to $8. 4 million, as a result of the subprime disaster which led to write-downs on subprime mortgages, collateralized bonds and leveraged loans. Standard Poors called this loss startling while analysts agreed that this was probably the largest loss ever to be faced by a Wall Street firm. Bankruptcies and losses are a dime a dozen in the financial world. In August 2007, the 10th largest retail mortgage lender in the U. S. , American Home Mortgage Investment Corporation filed for Chapter 11 bankruptcy. In the same month, Mortgage Guaranty Insurance Corporation, the largest provider of private mortgage insurance in the country announced that due to the billion-dollar loss it suffered on its investment in Credit-Based Asset Servicing and Securitization, it would now abandon the $4. billion deal which would result from its purchase of the Radian Group, a credit enhancement company. The impact was definitely had a global reach. In the same month one of the main banks of Europe and France, BNP Paribas announced that it will no longer value three of its funds (Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia) and that investors were no longer allowed to withdraw their funds. These funds comprise of U. S. asset-backed securities which include subprime mortgages, delinquencies on which have increased while prices have fallen. It took this decision in light of the extremely troublesome plight of the U. S. subprime market as according to the bank, the complete evaporation of liquidity in certain market segments of the U. S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating. The examples do not end here. Global Alpha hedge fund, with a worth of $8 billion and owned by one of the worlds largest global investment banks, Goldman Sachs, fell by 26%. Citigroup suffered colossal credit losses of $700 million in July and August 2007, and while the losses can not be compared to the banks profits of more than $20 billion in 2006, it will be very difficult for the bank to restore investor confidence. In the same month of August 2007, Sentinel Management Group sold off its assets and after three days of doing so, filed for Chapter 11 bankruptcy. Stock indices in U. S. , Europe and Asia continued to decline due to turmoil in credit and housing markets. Within the same week as Sentinel, shares of Countrywide Financial, the largest U.  S. mortgage lender, dipped by 13% on the NYSE amidst fears that the tight liquidity conditions might lead to its bankruptcy. This was the largest one-day decline in the countrys history since Black Monday, the stock market crash of 1987. Just a day earlier, the company had reported that foreclosures and mortgage defaults had never been this high since early 2002. Reverberations could be felt as far as Australia: shares of Rams Home Loans Group fell by 41% on the Australian Stock Exchange, as it could not refinance its loans as buyers did not want to buy AUD$ 6. 7 billion of commercial paper, its main source of funding. Australian Hedge funds, which were highly exposed to U. S. subprime credit, such as Basis Capitals Basis Yield Alpha Fund filed for bankruptcy protection. This fund filed for bankruptcy in August 2007 while in May its assets were valued at $1 billion. According to the IMF, The rapid transmission of disturbances in one part of the financial system to other parts, sometimes through opaque and intertwined channels, has surprised both market participants and the official sector. Impact on Housing Market The Housing Market could not help but be affected by the subprime market crash: sales of previously owned homes dipped to their lowest in four years. Prices plummeted and consumer confidence declined, as the U. S. economy in general experienced a slowdown. According to David Lereah, chief economist at the National Association of Realtors, purchases of existing homes, which had been 6. 68 million in February 2007, declined to an annual rate of 6. 12 million, which has been the largest drop since January 1989. as compared to 2006, sales declined by 11. %. Ben S. Bernanke, Chairman of the Federal Reserve, as well as other policy makers have isolated housing as the sector which would act as a deterrent for the economy to achieve moderate growth. This decline in sales has led to the general sentiment that the housing recession is here to stay. Subprime mortgage defaults show no signs of decreasing and owners do not wish to reduce prices, which will eventually lead to more unsold properties in the market. The housing bubble has definitely crashed as the supply of homes for sale dipped to 3. 45 million in March 2007, which if the current sales rate is accounted for, represents 7. 3 months supply, the highest since October 2006. Industry reports reflecting the SP/Case-Shiller home- price index reported the 1 percent decline in home values in 20 metropolitan areas, which is the largest price drop since the inception of this index in 2001. According to the Commerce Department, construction of new homes has gone down by 14. 3%. The nations major housing markets all reported decline in prices and existing home sales levels dropped in 40 states. The sharper hits were felt in the markets of Arizona, Florida, California, and Virginia. April 2007 had 47% more foreclosures than a year ago, as reported by RealtyTrac Inc. 50 or so subprime mortgage companies have either been sold off or closed down which has worsened matters and let to a credit crunch. D. R. Horton Inc. , the second-largest homebuilder in the country, suffered a drop in fiscal second-quarter profits by 85% as sales declined and the company was not in a situation to buy land. Its Chief Executive Officer, Donald Tomnitz, said, I dont think the market is stabilizing. Clearly our sales are not where we wanted them to be. The housing markets in California, Florida and Arizona are becoming tougher. While regulatory agencies are now becoming wiser to the risky mechanisms which deceptively forced millions of people into houses which were out of their range of affordability, their attempts to look into these practices will not be fruitful in the short term. There exist $1 trillion in Adjustable Rate Mortgages which will reset in 2007. This is a definite recipe for more disaster as over-leveraged homeowners will not be able to make their payments and will invariably default, leading to more trouble for banks and a chain effect which will adversely affect the already-weakened economy. Banks and mortgage lenders are trying to come up with ways to ensure that people stay in their homes but the subprime market in particular with increasing foreclosures and the housing market in general is in the midst of a spectacular crash.