Earlier this month, the three major US stock market indices lost nearly all the gains they had made since rebounding after February’s selloff, as reported by a Global Investment House “Global” fund analyst.
The Dow, the NASDAQ and the S&P each fell by around 2%, dragged down by financial firms and retailers as increasing mortgage defaults heightened concern that further weakness among the riskiest borrowers will slow the economy.
Dalal Hisham Al-Rayes, fund analyst at Global Investment House stated that, “subprime mortgages are housing loans made to borrowers with poor credit histories or no credit history and therefore do not qualify for lower prime market rates.
A weak credit history may include late credit card payments, one or more missed mortgage interest payments, and previous notices of default. Lenders subsequently adjust their underwriting criteria to reflect the increased lending risk by charging interest rates at least 2-4% higher than conventional loans to compensate for the increased future probability of default, added Al-Rayes.
She noted that, until recently, the level of bad debts recorded by most subprime lenders has been relatively low. Rising home prices in the US for the past couple of years made subprime lending a very lucrative business, with lenders ranging from investment banks to hedge funds. Borrowers who could not make their mortgage payments refinanced their loans at more attractive rates, or sold their houses, paid off the lenders and gained small profits. As the US housing market rose, lenders began offering exotic loans to attract new entrants into the housing market. They offered adjustable-rate mortgages with low introductory rates that were fixed for around two years which then reset to a higher adjustable rate for the remaining life of the loan. Other loan products included interest-only loans and mortgages in which the monthly payment was less than the accrued interest.
Three quarters of the adjustable rate subprime loans written in 2004 and 2005 will reset this year to the higher current interest rate levels, making it difficult for borrowers to make the larger payments. Most of these loans were underwritten assuming borrowers would refinance into new, cheaper mortgages before the rates were reset. However, interest rates are higher than they were and lending standards have tightened, making it harder for borrowers to qualify for new loans. Many borrowers have substantial debt and little equity in their homes to borrow against, leading to rising defaults and foreclosures.
New Century Financial, the second largest US subprime mortgage lender, has been among the more prominent names to be affected by the rise in defaults. A slowdown in the US housing market coupled with rising interest rates have hit the company’s profits. New Century was forced to stop offering new loans and was delisted from the New York Stock Exchange after it couldn’t meet creditors demands for cash. New Century’s stock fell to a price as low as $1.01 (down from a peak of $51.97 last May) amid fears that the firm may be heading for bankruptcy.
Al- Rayes stated that according to Bloomberg, more than two dozen other mortgage lenders have gone bankrupt, closed operations or sought buyers since the beginning of 2006. Their profits have been wiped out by soaring default rates and falling demand for new loans, leaving the firms with no forms of financing. Subprime troubles have also begun to impact the homebuilding sector.
The Federal Reserve and other bank regulators have released proposed guidelines instructing banks to toughen their underwriting standards and offer clear disclosures on loan terms to subprime borrowers. Stringent regulation will likely worsen the situation for subprime lenders.
Although the subprime market is a very small portion of the overall mortgage market, it serves as a warning of potential problems to come. As defaults and foreclosures dump houses on already saturated markets, prices may be further pressured lower, meaning that selling homes to cover increasing debts may not be an option, Al-Rayes added.
She stressed that the fall in the subprime market has had a negative impact on the risk appetite of investors. They are allocating money to Treasuries in a defensive move as equity markets continue to struggle. This could lead to a credit crunch, with investors shying away from securities backed by prime mortgages or other less risky assets, not just subprime, withdrawing liquidity from the market and hurting all borrowers.
Al-Rayes concluded that the housing slowdown will have a drag on GDP growth, firstly, by slowing the construction industry and bringing related employment growth to a standstill, and also by making consumers feel poorer, significantly reducing their consumption. As consumer spending makes up around 70% of US GDP, this reduction combined with contracting credit could result in major weakness in the US economy.
Nevertheless, markets ended last week in the positive after a surprise jump in February’s home sales data eased concerns in the market, showing that much of the housing problem has been priced in by investors. Although the housing market has not bottomed out, the positive data helps alleviate some of the worries associated with the sector.
