sub prime crisis explained

Sub prime mortgage crisis

explained

The so called 'subprime crisis' has rarely been out of the headlines since the second half of 2007. The whole crisis really has turned into much more than just a subprime issue, in fact many fear that the crisis has now evolved into the beginnings of a US (and possibly even a Global) recession. What is certain is that the negative sentiment currently in the worlds economies was triggered by the sub prime mortgage market in the US.

After many years of sustained house price increases the US housing bubble finally burst in early 2007. In the years prior to this sub prime mortgages were more frequently sold. Of all mortgage originations in the US in 2006, over 20% were sub prime This compared to only 9% in 1996. Also discounted mortgages, or teaser rates as they are referred to in the US, became widespread. While prices were rising borrowers could easily refinance when their discount or teaser period ended and their monthly repayments shot up. However as property prices began to fall, refinancing became much harder. As a result the number of people defaulting on their loans increased dramatically leading to more and more properties being repossessed by mortgage companies. In fact in December 2007 over 1 million homes were in the process of being repossessed in the uS. This had a dramatic effect on several areas of the financial system:

Mortgage Originators

As many of their customers defaulted on loans, the mortgage companies were forced to repossess many homes. This would not have been a massive problem to the mortgage companies had prices not been falling. According to the Standard & Poor's housing index, in Q3 2007 US house prices were down 4.5% compared to the same period a year earlier, the sharpest drop in 21-years. Suddenly the mortgage lenders were repossessing homes that were less worth than the loans that they had originally lent to buy them. This resulted in many of these firms making huge losses. This had dramatic affects, for example American Home Mortgage Investment Corporation, which was the 10th largest retail mortgage lender in the United States, filed for bankruptcy in August 2007.

The Sub prime Virus had already spread

Obviously mortgage originators making losses and even some going bankrupt had negative effects on the US economy (negative sentiment, increased unemployment, fall in share prices, negative effect on the housing market etc) however the links to the rest of the economy were much more deep rooted.

Many mortgages debts were sold of by the mortgage originators and sold of to investors to other financial institutions. This process known as securitisation became increasingly popular in recent years. Essentially a bank would buy up a pool of mortgage debt. Banks or originators then packages up the debt and sold it off to others as a security in its own right, what became known as a Mortgage Backed Security (MBS). These securities can be thought of as very similar to that of a traditional bond or gilt. The buyer effectively has a large initial outlay to buy the bond/security which he/she hopes will be repayed back with interest by the coupon or interest over the life of the security.

In the case of MBS products the interest or coupon that the investor should receive is the future repayments that the original mortgage holder should make. In other words the risk that people wouldn't be able to pay their mortgages payments each month had been transferred in my cases from mortgage lenders to other financial institutions such as banks, pension and insurance companies.

Because of the credit risk involved with MBS products they are by nature very hard to value. Many o the holders of these securities had no sophisticated way to value these products. As the crisis deepened and house prices continued to fall, so too did the value of these MBS securities. As a result several of the worlds financial institutions have revealed hue losses or write downs against their sub prime holdings:

- CitiGroup (Investment Bank) over $24bn
- UBS AG (Investment bank) over $18bn
- Swiss Re (Insurance) over $1.8bn

It is feared that as the crisis continues and the US appears to b on the edge of slipping into recession, that even more loses could filter out of the financial system, potentially causing a global economic slowdown or recession.