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Real Business : Winter 2008
30 REAL BUSINESS ISSUE 2, 2008 BY JANE-ANNE LEE CH! UN CR THE US SUB-PRIME CRISIS HAS CAUSED CREDIT PROBLEMS ALL OVER THE WORLD F inancial markets all around the world run on debt. It provides credit for governments, companies and individuals. It might sound simple, but in the past few years things have become very complex as investment banks devised a wide range of new investment products based around such loans. Take for example sub- prime loans (loans to those with a poor credit record or a lack of security) in the US. Instead of keeping these risky loans on their own balance sheets, the lenders bundled these up into pools of loans – a process known as “securitisation”. These pools of loans were then on-sold into the global investment markets. To make these risky loan pools seem more palatable to investors, investment bankers and financiers packaged them with higher quality loans into products called collateral- ised debt obligations (CDOs). These were given high ratings by agencies and then sold to investors. Based all around the world, these investors took on the risky loans (now called sub-prime mortgage-backed guarantors) for the promise of fat returns. Everything was fine until the US housing market started to turn down and sub-prime borrowers began to default on their loans – and then things went dramati- cally awry. Banks and other lending institu- tions suddenly became scared about lending money – even to each other. Availability of credit dried up. SO WHAT EXACTLY IS THE US SUB-PRIME CRISIS? “Some people mistakenly believe they (sub- prime loans) are like our [Australian] low-doc loans, which are known as Alt-A in the US,” says Rod Cornish, head of real estate research, Macquarie Group. “But sub-prime loans are a lot riskier than low-doc because they [were often] given to people who have previously defaulted or been bankrupt. These borrowers haven’t got a record of working through loans at different phases of the cycle.” In the US, when you take out a variable rate mortgage, there is usually a two-year honeymoon rate. After the US market peaked in late 2005, those honeymoon rates came to an end around August 2007, so those who had taken out a loan at the peak of the housing market were in line for their first rollover of interest. “People were rolling over mortgages at a significantly higher variable interest rate, depending on when they took out the original mortgage,” Cornish says. “At the same time, property values tumbled.” In the US, borrowers who cannot meet their repayments can simply hand back their keys and walk away. “The bank has a choice of taking action against you or chasing the LOWDOWN: GLOBAL CREDIT CRISIS property, and they will usually choose the property,” Cornish explains. So what role is the sub-prime crisis playing in the global credit crunch? Although many people may have been aware of what was happening with the US housing market, what they didn’t realise was the extent to which large overseas institutions had invested in the directly connected sub-prime mortgages. “They were investing in a pool of securitised mortgages to gain a higher interest rate,” Cornish says. “That pool included sub-prime. These institutions reported that they weren’t aware they had such a large proportion of the pool in sub-prime. Those same overseas institutions have since acknowledged that, and reported losses, which has had a widespread global impact on the credit market.” The US sub-prime crisis began to spread globally when the British financial institution Northern Rock found itself heavily exposed as its usual source of sub-prime-related funding dried up. Its shares plummeted by almost a third as investors lost confidence, and a rescue effort was required from England’s central bank. Many institutions or individuals who thought they’d invested in things that were quite low-risk, discovered they’d invested in mortgage-backed securities, CDOs and other risky assets. Hedge funds were big buyers of sub-prime
Issue 3 2008