The sub prime lending crisis - never again!
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Posted Jun 16, 2009
Dear Wizard Learner After reading each month's news update subscribers take an assessment with their results and CPD being recorded on their CPD certificate. Have a go at this month’s assessment
The loans, usually variable rate mortgages were referred to as “sub-prime” mortgages. These loans typically charged an interest rate two or three percent above those offered to more creditworthy borrowers and carried interest rate structures with low “teaser rates” for the first couple of years, followed by much higher rates afterwards. The jump in interest rate, often caused the borrower’s monthly payment to increase by as much as 100% and thereby making it financially impossible for him to pay. To compound the problems being stored up by this method of lending, many new homeowners were seeing a rising value to their homes during the initial year or so of their mortgages and frequently took out further secured loans to raise extra cash. Meanwhile, banks and financial institutions were playing their part towards meltdown, by trying to increase profitability from lending through a method called securitisation. This allowed money to be lent again and again through asset leverage thereby raising more loan capital to the mortgage market. “Packages” of loans of varying degrees of risk were developed and sold to worldwide investors as financial instruments called “CDOs” or collateralised debt obligations. In the early part of the decade, the mortgage market continued to be solid so long as the housing market carried on escalating in value and interest rates stayed relatively low. However, worryingly, homeowners were continuing to incur more and more debt. By 2006, housing prices in the US were tapering off after dramatic rises since the turn of the century. As sub prime mortgage interest rates began to “reset” in droves and result in foreclosure, housing prices declined. Because of the way these loans and CDOs were globally distributed, it knocked the whole system into turmoil. A single CDO package might contain as many as 100 sub-prime mortgage loans. As the defaults continued, the worldwide CDOs became almost impossible to value and markets worldwide went into freefall. Banks began to reveal large write downs in 2007 on the value of their credit assets due to the high numbers of defaults taking place. They also became fearful of lending to each other usually on the premise that they either wanted or needed to boost their own reserves or, they were wary of the hidden risks they could be exposed to within trades. At various points in late 2007 and throughout 2008, the markets reached crisis points culminating in real liquidity problems. Eventually only the major governments could bail us all out with huge levels of their own borrowing (that we shall all be paying back for years to come) being pumped into the system to create the necessary liquidity to allow the markets to operate. Let’s hope the worst really is over and that stricter control and monitoring of the financial system will be put in place to make sure this does not happen ever again! Wizard Learning
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