Sub-Prime Mortgage crisis in America, its on-going fallout, and does this issue impact Malaysia ?

By Roland Lee, 3 May 2008

There has been questions asked whether the ongoing sub-prime mortgage crisis especally in developed countries has an impact on a developing country like Malaysia. To address this question it is necessary to understand what is the cause of the crisis first, what has transpired and then address the issue.

1. MAIN CAUSE
The main cause of the sub-prime crisis in the American financial system is a sharp increase in MORTGAGE FORECLOSURES, mainly subprime, that collapsed numerous mortgage lenders and hedge funds. One of the major factors that brought around this crisis in “sub-prime mortgages” in the US were loans made to not- so- credit-worthy households to buy houses.

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.

2. HISTORICAL IMPACT
Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage defaults and foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation’s second biggest subprime lender that went into bankruptcy when they could not meet US$150 Million worth of margin calls from its warehouse lenders.

Another major failure is Countrywide Financial Corporation, a diversified financial marketing and service holding company, that at its height in 2006 financed 20% of all mortgages in the U.S. at a value of 3.5% of U.S. Gross Domestic Product, a proportion greater than any other single mortgage lender. The bail-out of Countrywide Financial resulted in the company being purchased for US$4.1 Billion by Bank of America in January 2008.

The failure of these companies has caused prices in the $6.5 trillion Mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The crisis is ongoing and has received considerable attention from the U.S. media and from lawmakers during the first half of 2007.

3. MELTDOWN SPILLOVER
The meltdown spilled over into the global credit market as risk premiums increased rapidly and capital liquidity was reduced. The sharp increase in foreclosures and the problems in the subprime mortgage market were largely due to loose lending practices, low interest rates, a housing bubble and excessive risk taking by lenders and investors.

Similarly in U.K., Northern Rock plc, a British bank that in 2000 was a FTSE 100 Index company, sought and received a liquidity support from the Bank of England in September 2007 following problems in the credit markets caused by the US subprime mortgage financial crisis. However in January 2008 as a result of two unsuccessful bids to take over the bank, Northern Rock was nationalized.

4. RE-PACKAGED SUB-PRIME DEBTS + CONSEQUENCES
However, the sub-prime mortgage crisis has had far-reaching consequences across the world. Tranches of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the sub-prime mortgage industry, those who bought into the markets suddenly found their investments almost worthless or impossible to accurately value.

5. MARKET PARANOIA
With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary healthy businesses with no affiliations to the sub-prime crisis suddenly started facing difficulties or even folding due to the banks’ unwillingness to budge on credit lines.

6. ROOT CAUSE
Some say the sub-prime problem is an emanation of the use of credit that started 25 years ago during the Ronald Reagan era in the US and during the Margaret Thatcher era in UK. The use of excessive credit led to periodic crisis. It was an era that believed that financial markets should be left on their own with minimal or non-existent regulator interference. Now we are seeing the turn-around where there is doubt that such an environment can proceed without regulations.

7. FURTHER POTENTIAL FALLOUT — Credit Default Swap (CDS)
Now that the subprime mortgage crisis appear to be stabilized by various actions taken by central banks and governments, another potential major problem is looming in the horizon as an offset of the subprime mortgage problem. This is the Credit Default Swap (CDS) that is an unregulated financial market that has a US$45 Trillion bubble. The CDS resemble an insurance policy as it is an instrument to transfer the credit risk of fixed income products. The buyer of a credit swap receives credit protection. The seller ‘guarantees’ the credit worthiness of the product. Simply, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Recently, a bond insurer, ACA Financial Guaranty Corp., has problems to unwind more than US$60 Billion of insurance contracts it sold to financial firms. The contracts are intended to protect Wall Street firms from losses on mortgage securities and other debts they own.
Bond Insurance is a service whereby issuers of a bond can pay a premium to a third party, who will provide interest and capital repayments as specified in the bond in the event of the failure of the issuer to do so.

8. IMPACT ON MALAYSIA
For Malaysia, it is fortunate that the mortgage loan industry has followed a strict and prudent process of checking out the credit-worthiness of an applicant before lending proceeds. Thus the usefulness of procedural checking via CCRIS (a credit control bureau) to check on repayment record of an applicant plus the use of CTOS for checking on bankruptcy record of the applicant, have certainly eliminated or minimised the possibility of a sub-prime issue arising within our mortgage industry.

9. INDIRECT IMPACT OF SUB-PRIME PROBLEM ON MALAYSIA
The direct impact of the sub-prime mortgage problem though minimal or non-existent may have an indirect impact. This indirect impact can be seen from such issues like:-

a) Lowered direct and indirect imports of Malaysian exports into the U.S. due to lowered consumption in the U.S. as a fallout due to the impact the sub-prime mortgage crisis had on the U.S economy.
b) Lowered demand for high-end rental properties especially in Kuala Lumpur and Petaling Jaya due to down-sizing of global operations by major U.S. and European companies as a consequence of the anticipated slowdown or recession in the developed world.

10. AND FOR THE IMMEDIATE FUTURE ?
George Soros, the well-known international investor, was quoted to have recently said,

“We are now in a period of financial wealth destruction. Global markets were in a period of rapid, massive de-leveraging that would fuel volatility.”

These words from a respected guru certainly calls for a cautious approach to investing in the coming future. Take care!