Overview of the sub-prime market meltdown
by Ingrid Goodspeed
Governor SAIFM

On 13 July 2007 the FTSE / JSE All-share index briefly touched 30 000 – its highest level yet. One month later the index was 13% lower as concerns about the extent, distribution and valuation of exposures to US sub-prime mortgages cast a dark cloud over global financial markets.

The objective of this article is to describe the background to and impact of the sub-prime market meltdown.

1. Origins of the meltdown

Best banking practice requires banks to have sound and clearly-defined credit-granting standards. Generally these relate to character (credit reputation of the borrower), capacity (ability to repay new as well as existing debt) and collateral / capital (asset offered as security for the loan). While these standards protect the capital of banks, they limit the number of lenders to whom banks are willing to grant loans. Thus sub-prime borrowers, who are lower income borrowers with tainted credit histories, would generally be excluded from obtaining loans – including mortgage financing.

Furthermore traditionally banks hold loans to maturity / redemption and bear and manage the credit risk associated with the loans until such maturity / redemption. For this, banks earn net interest income – the difference between the interest received on the loan and interest paid to fund the loan. With the advent of securitisation (see insert) banks effectively transferred this risk to investors.

Between January 2001 and December 2001 the Federal Reserve cut the benchmark interest rate 11 times to protect the US economy from the technology bubble, 9/11 and fears of deflation. In December 2001 the Fed rate was 1.75%. The low interest rates meant loans became affordable even for low-income borrowers. This combined with financial innovation such as securitisation and credit default swaps changed the face of mortgage banking. Banks that once held loans to maturity, simply wrote them and sold them, often within a matter of weeks. In the last 5 years over 80% of all loan production was securitised.

As demand for loans increased to fuel the profitable securitisation mechanism, low-income / bad credit home loans presented an untapped source of raw material that packaged with credit insurance produced investment grade securities demanded by institutional investors and money managers worldwide. The majority of these sub-prime loans were adjustable rate mortgages.

In the mortgage packaging business, traditional packagers such as Fannie Mae and Freddie Mac were crowded out by more aggressive investment houses and banks such as Bear Stearns and HSBC. In addition non-bank companies such as New Century Financial and Accredited Home Lenders or divisions of non-bank companies such as General Electric entered the market.

As global capital flowed into the US housing market, the prices of houses rose, which slowed down the writing of home loans for securitisation. The need to ensure deal flow triggered the creation of exotic home loans options such as loans that required no deposit, allowed borrowers to pay only interest or skip repayments completely. “Liar loans” allowed borrowers to claim a given income. At the extreme “ninja (no income no job or asset) loans” enabled borrowers with no income or employment to have a home loan. Credit-granting standards virtually ceased to exist.

What is securitisation?

Essentially securitisation is the replacement of traditional bank credit such as mortgages by instruments that are tradeable in financial markets. The following description is a simplification of a complex process.

Mortgage packagers such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) purchase mortgages from banks and package them into securitisation issues, called mortgage-backed securities (MBS) that are sold to investors. To make the issues more palatable to investors mortgage insurance or credit default insurance such as credit default swaps (CDS) are included in the package.

A related innovation is collateralised debt obligations (CDO) or collateralised loan obligations (CLO). To create CDO or CLO, money managers purchase portfolios of MBS for a trust, which issues CDO / CLO backed by those MBS.

Other players in the process are:

  • rating agencies that place a rating on MBS and CDO and
  • investment banks that act as underwriters and placement agents for MBS and CDO.

2. Countdown to crisis

From June 2004 to June 2006 the 17 increases in the Fed rate started to impact US borrowers. House prices levelled off and began to fall. In February 2007 sub-prime mortgages defaulted at a rate of 12.5% versus 1.5% for prime mortgages.

On 7 February 2007 HSBC, Europe's biggest bank, announced a bad debt charge $1.8bn higher than expected (to over $10bn) due to problems in its US mortgage book. On 2 April 2007 New Century, US's largest independent sub-prime lender filed for bankruptcy.

From end-May 2007 certain key events evidenced the near meltdown of the global financial system. These are shown in the graph on the next page against the level of the FTSE / JSE All-share index.

Basically, the discovery of problems in the sub-prime market as well as a stream of negative news out of the US housing market rapidly led to a loss of confidence in the ratings of MBS. As confidence in the valuation of MBS and CDS decreased, credit spreads widened. With investors’ appetite for credit risk disappearing, the price of credit risk increased sharply. On the other hand the yield on government securities fell as investors sold riskier assets and moved to the relative safety of government securities. Demand for liquidity surged, which led to a squeeze across financial markets and prompted central banks to inject large amounts of liquidity into the system

The collapse of the sub-prime bubble was initially seen to be relatively contained. However, spillover effects into other markets notably commercial real estate markets quickly materialised. Also under the weight of mounting losses from the repricing of credit risk, equity markets saw broad-based declines in prices with housing-related and financial sector shares generally underperforming the wider market.

In the emerging markets bond spreads rose significantly. The EMBI Global saw spreads rise from its all-time low of 151 basis points in early June 2007 to 260 basis points in mid August 2007. By end August spreads had tightened to 238 basis points. Emerging market equities were fairly resilient. The MSCI lost about 15% of its high on 23 July 2007 before recovering late August.

3. What now?

As with other financial disruptions (e.g., the Savings & Loans collapse and credit crunch of the 1990s, the Asian financial crises and failure of Long-term Capital Management in 1997 and the 2002 breakdown of corporate governance, financial disclosure and other standards with the collapse of Enron and WorldCom), there is sure to be a policy response to some if not all of the following issues uncovered by the sub-prime conflagration:

  • There has been a loss of confidence in ratings agencies as securities and debt rated as investment grade proved to be highly risky and rapidly headed to default. In addition the validity of the financial models and assumptions used by rating agencies to estimate the risk of securities and debt has been questioned. There is also room for debate over whether the perceived errors and slow response of the rating agencies stem from the conflicts of interest that arise when debt issuers pay for their ratings.
  • The crises centred on non-financial institutions, which firstly had insufficient capital for the risk on and off their balance sheets and secondly were unable to find funding when investors lost confidence in them and sought to redeem their investments and moved into less risky and more liquid investments;
  • There is growing separation between credit origination and ownership and management of the associated credit risk. Institutions involved in mortgage origination are not motivated to limit the risk of investing in the mortgage. In other words, institutions responsible for making loans have limited interest in the performance of those loans while institutions with financial interest in the performance of the loans have limited involvement in how the loans are made. Thus the transfer of risk that is the result of securitisation has led to a lack of credit-granting diligence and dysfunctional markets.

While there have been signs of a return to normality, it is evident the sub-prime meltdown has not yet run its full course. US numbers announced at the beginning of September 2007 confirm this:

  • Inventory of unsold homes is at its highest level in more than 15 years
  • In August planned layoffs of companies rose 85%. Job cuts in the financial sector were the highest since 1993;
  • In July 2007 there was 12.2% decline in pending home sales – one of the largest ever drops in the history of the data series.

Abbreviations:

ABS Asset-backed securities CDO Collateralised debt obligations CDS Credit default swaps
CLO Collateralised loan obligations CMBS Commercial mortgage-backed securities MBS Mortgages-backed securities
RMBS Retail mortgages-backed securities  

Reference sites:

www.cnn.com www.reuters.com www.bis.org
www.worldbank.org www.ft.com www.economist.com