Tuesday, July 15, 2008

US Sub-Prime Mortgage Crisis

Towards the end of last year, the term sub-prime mortgage debuted in our news reports. We uttered the term 'macam expert' but how many really know the real meaning? Here, I would like to share a good write-up from BBC. (http://news.bbc.co.uk/2/hi/business/7073131.stm).

The US sub-prime mortgage crisis has lead to plunging property prices, a slowdown in the US economy, and billions in losses by banks. It stems from a fundamental change in the way mortgages are funded.

How it went wrong
flow chart

Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do. In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing. But it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issued.

In the past five years, the private sector has dramatically expanded its role in the mortgage bond market, which had previously been dominated by government-sponsored agencies like Freddie Mac. They specialised in new types of mortgages, such as sub-prime lending to borrowers with poor credit histories and weak documentation of income, who were shunned by the "prime" lenders like Freddie Mac.

The business proved extremely profitable for the banks, which earned a fee for each mortgage they sold on. They urged mortgage brokers to sell more and more of these mortgages.

For many years, Cleveland was the sub-prime capital of America. It was a poor, working class city, hit hard by the decline of manufacturing and sharply divided along racial lines. Mortgage brokers focused their efforts by selling sub-prime mortgages in working class black areas where many people had achieved home ownership.

They told them that they could get cash by refinancing their homes, but often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate. The result was a wave of repossessions that had a dramatic effect on house prices, reversing the housing boom of the last few years and causing the first national decline in house prices since the 1930s. There is a glut of four million unsold homes that is depressing prices, as builders have also been forced to lower prices to get rid of unsold properties.

It triggered down to broader economy with builders going out of business, bankers cutting back on credit etc.

So can start debating with the politicians which I doubt have a clue on the matter!


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