COLLAPSE OF THE U.S SUBPRIME MORTGAGE MARKET AND ITS FALLOUT

MAHVISH JADOON
Sep 03 - 09, 2007

The crisis in the US subprime mortgage industry is showing no signs of receding. The real estate boom which was called the "biggest bubble in history" two years ago by The Economist, as housing prices in the US rose, may be over for a long time. Bad lending practices caused housing prices to go up and with borrowers unable to pay back their loans resulting in a record number of foreclosures. Home foreclosures in June rose 93 percent from a year ago, according to RealtyTrac, an online marketplace for foreclosure properties. The ensuing liquidity crisis as people invested their money into safer investments and bonds caused the US Federal Reserve to inject huge amounts of cash into the market.

FALLOUT ON THE REST OF THE WORLD:

The fallout from the subprime mortgage crisis on the European markets has also caused the European Central Bank to lend more than US$130 billion in order to beat the credit crisis. Germany has been the worst affected due to exposure to bad mortgage loans in the US with two of its banks almost collapsing. The Bank of England had until now not taken an active role unlike American and European central banks, but it has also now loaned US$3.2 billion at its highest rate as UK lenders are finding it hard to borrow money.

In the Asian market banks have been more or less insulated by the subprime fallout. Among the Asian banks the Bank of China has reported the greatest exposure of US$9.65 billion in investments in subprime related securities. This exposure accounting for around 7.5% of its foreign currency investments is still not large enough to threaten the bank. Elsewhere in Japan the exposure reported by the Japanese banks is around US$4.5 billion dollars and has caused Japan's central bank to inject money into the economy. Overall the stance taken by Japan's policy makers has been optimistic of weathering the storm.

The greatest threat to the Asian markets has been fears of a recession in the US which would decrease demand for exports. "A slowdown in the U.S. housing market will certainly affect demand for appliances and electronics goods," said an official with South Korea's LG Electronics, reports China Post. There have been drops in stock indexes owing to a global flight from risky investments in Asian markets. Most Asian banks do not depend upon funding from riskier debt instruments as compared to their US and European counterparts and more on domestic financing and are therefore more or less safe from the subprime fallout.

Pakistan's stock indexes have taken a battering recently more pronounced than that experienced by other Asian markets. This has been attributed to a fall in investor confidence due to the immense political instability and uncertainty in the country. According to reports Foreign Direct Investment has fallen by 14.8 percent in July as compared with the same month of the last fiscal year. Analysts argue that Pakistan's economy has a low correlation with the US economy and continuing turmoil may actually be beneficial to the economy if it brings about a reduction in the price of crude oil.

BACKGROUND:

The current financial crisis in the US subprime market has been widely acknowledged to be due to bad lending practices that enabled high risk borrowers to obtain housing loans. The lending spree may be dated back to September 2001 when the Federal Reserve decreased borrowing costs by half a percentage point to keep the economy from falling into recession due to the attacks on the World Trade Centre. Benchmark interest rates were also decreased by the Federal Reserve eleven times from 6.5 percent in January 2001 to 1.75 percent in December of the same year. This caused a huge demand for homes which in turn increased housing prices substantially. During the period of June 2004 to June 2006 interest rates were increased from around 1.5 to more than 5.0 percent which caused problems for borrowers, especially those with Adjustable Rate Mortgages or ARM's.

These bad loans which left people with mortgages they could not afford to pay back were packaged up with other reliable debt and sold off to private banks around the world. There have now been calls from foreign investors who were caught by surprise as they suffered losses from these products to have more transparency, as American rating agencies gave top ratings (AA, AAA) to these securities and mortgages. "In a globalized economy with hedge funds, leveraged buyouts and all these investment funds, we have to ask the question about more transparency," said Claude Bebear, the chairman of the supervisory board of the insurance company AXA, according to The New York Times. A member of the German government's economics advisory board Peter Bofinger also said: "America depends on the rest of the world to finance its debt. If our institutions stopped buying their financial products, it would hurt."

There are rising fears that the subprime mortgage mess will have fallout on other sectors of the economy such as credit cards or auto loans. The Federal Deposit Insurance Corporation of the US has recently reported that late loan payments on all sorts of loans have been rising as banks tighten up their standards for more loans. Against such a back drop Federal Reserve Chairman Ben Bernanke will make a speech in an annual monetary conference on Friday. The Fed may reduce its primary discount rate more than the half point it did on August 17 in order to ward off a credit crunch. President Bush will also be proposing reforms on Friday in a move to help homeowners with subprime mortgages to avoid default.