Global financial markets are experiencing
tremendous declines in
value over the last few quarters,
with losses estimated to exceed trillions of
dollars. The uncertainty in stock markets,
caused by concerns regarding banks' and
financial institutions' solvency, is contributing
to a global economic slowdown. The resilient,
$50+ trillion world economy may be in trouble
and it all started with a relatively small percentage
of home loans in the United States.
The current crisis took root about six years
ago when interest rates were at historic lows
and mortgage lenders in the United States
were providing quick and easy mortgages to
almost all who applied. Between 2002 and
2006, millions of Americans bought real
estate and millions of new mortgages were
underwritten. Home values increased to
record levels in many metro areas across the
United States.
With a few exceptions, all was going well until early 2006 when interest rate increases by the Federal Reserve Bank (FRB) began to take hold, home building inventories peaked, talk of a housing price bubble increased and the boom in housing started showing signs of trouble. Many borrowers began having trouble paying their monthly loan payment and started to sell - flooding the market with homes they could no longer afford. Falling housing demands, coupled with an increasing supply, created a glut of homes on the market and home prices fell - and are still falling. What started the flood of homes on the market were interest rate resets from loans approved years earlier during the mortgage underwriting boom of 2004 to 2006. Included in these millions of mortgages were a significant portion of loans provided to "sub-prime" borrowers - buyers with lower credit ratings. To approve loans to these "questionable" borrowers, mortgage lenders steered these customers into adjustable rate mortgages (ARMs) in which the initial interest rate is very low, a "teaser rate," and it then re-adjusts to a higher level after one or more years. The advantage to these "teaser" loans was that the reduced introductory interest rate kept monthly mortgage payments low and allowed millions of "sub-prime" borrowers the financial ability to purchase a home. However, the disadvantage, and what has led to the current crisis in the financial industry, is that once the low rate readjusted upward years later, millions of borrowers could no longer afford their homes. Here's the math. A sub-prime borrower buys a home in April of 2005 with a $150,000 three-year ARM mortgage. In April of 2008, the loan's teaser rate of 5 percent resets to 8 percent and the monthly payment - overnight - increases $296 or 37 percent. The homeowner cannot afford the new payment and decides to sell.
Unfortunately, so many other people are
in the same boat that too many houses are
on the market, and prices are driven down.
The homeowner is left with a house worth
less than what is owed on it and no means
to make the monthly payment, so they walk
away and allow foreclosure to occur.
This is happening all over the country and
foreclosures are at record levels in many
metro markets. The higher monthly payment,
coupled with an already depressed housing
market and slowing economy, is creating an
avalanche of foreclosures and is driving
home prices down even further.
In earlier times, the local bank, credit union, or savings and loan would have underwritten and serviced their mortgage loans and suffered the consequences of poor approval decisions, but not in today's global economy. Individual mortgages are now grouped together with mortgages from all over the country to form other types of financial instruments. These new assets contain thousands of individual mortgages with a bundled loan value in the hundreds of millions of dollars or more. These assets are then bought and sold by huge global banks and investment groups, and they become integrated into global financial portfolios. However, the sub-prime crisis in the United States has led to a tidal wave of concern in the financial community. The true value of these mortgage-backed assets cannot be established since the underlying financial instruments are very complicated. The asset holder has no ability to quantify the underlying risk since so many unknown factors exist: What are the values of the collateral homes in a falling housing market? How many borrowers in the asset are at risk for default and how is this changing? What is this asset really worth? The result has been that international investors are selling these mortgage-related assets, and their values have fallen dramatically, leading to billions in losses.
This has created another major problem - the "Credit Crunch." Billions of dollars worth of mortgage-backed bonds and securities are held by financial institutions around the world and - this is the problem. The value of these assets are unknown and now large banks are nervous about loaning money to other banks because they don't know or trust each other's financial solvency. Because there is so much uncertainty and lenders are tightening their purse strings, the FRB has stepped in to stabilize with aggressive monetary policies. Interest rates have been cut significantly to ease the pain of rate resets for ARM borrowers and the FRB has loaned billions of dollars to financial institutions to ease the tightening of credit among banks. However, these actions have only slowed the tightening of credit in the U.S. economy and have had little impact on the collapse in the housing sector.
There may be light at the end of this tunnel, though. The huge wave of sub-prime resets will pass by the end of 2008, easing the downward pressure on the housing sector and mortgage-backed assets. The U.S. Congress is implementing programs to help homeowners avoid foreclosure.
Expansionary monetary policy by the FRB will begin having a significant impact on the economy, leading to stronger economic growth in the later part of 2008. Banks and financial institutions have recognized the asset and credit problems and are correcting their investment portfolios.
In the end, the financial losses incurred from easy mortgage loans to sub-prime borrowers over the last six years will impact the U.S. and global economies for years to come.
Charles Chesbrough can be reached via Email at CharlesChesbrough@csmauto.com.
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