US sub prime market – What is it and why does it matter?

What is the US sub prime market?

The “US sub prime market” is a part of the residential mortgage market in the US and is characterised by low income borrowers who have a bad credit history in servicing their home loans. In 2005, the United States real estate market experienced an all time high and as part of this, financing became more creative to make owning a home more accessible to the wider population – in particular, to those who may not have otherwise been able to afford to do so.

Characteristics of the changes in lending practices included:

• Credit became available to low income members of the community with a poor credit history, who are known as ‘sub prime borrowers’.
• Low-start and teaser rate loans – the ‘catch’ to these types of loans was that they included an interest rate reset condition that doubled the initial loan rate after a short period of time.
• Honeymoon rates – Some initial interest rates were as low as 1% to 2% for the first two years then they increased to the standard rate of 7% pa. This caused sub prime borrowers to default as they could not keep up with the repayments on their loans.
• High Loan to Value Ratios (“LVRs”) – some as high as 140%. Traditionally, LVRs do not usually exceed 80%. As property prices began to fall, this made the position of the sub prime borrower even worse.

Therefore, as the interest rates increased on these types of loans, many sub prime borrowers could not meet on their repayments, and so defaulted on their loans. It is now believed that up to 7 million people in the US have taken out sub prime mortgages.

Why has this fallout in the US sub prime market affected other markets around the world?

The crisis spread because many sub prime mortgages in the US have been “packaged” by lenders with the help of investment banks and sold around the world to financial institutions and hedge fund managers. These packages are often referred to as ‘Collateralised Debt Obligations’ (“CDOs”).

In basic terms, as the value in the US real estate market began to decrease and the level of defaults began to increase, the investments in these CDOs became non viable to the point where many major investors lost substantial amounts of money. Two Australian fund managers who have been affected are Basis Capital and Macquarie Bank through its Fortress Products.

There has been some concern that the Australian mortgage market may follow suit. However in Australia there are significant differences, so that it is unlikely that the negative impact will flow into Australia.

What  are the differences for most Australian Lending Institutions?

Because the approach to lending by the majority of Australian Banks and mortgage lenders, the problems experienced in the US sub prime market should not affect Australia, for the following reasons:

1. The basis of funding the underlying loans is different     Most home loans in Australia have neither been packaged in the way the US loans have been nor have they been funded by the US capital markets, so most lenders are not directly exposed to this specific risk in the broader financial markets. In the US, most mortgages are issued on a fixed 15 or 30 year mortgage basis, while the underlying funding is from short term capital markets debt paper.
2. Borrower capacity testing      Australian lenders that do lend to sub-prime borrowers assess the capacity of borrowers to service their loan commitments by obtaining (depending on the circumstances) a combination of:
   • an independent credit check on the borrower;
   • a letter from the borrower’s accountant confirming the borrower’s repayment ability; and
   • a repayment declaration from the borrower.
3. In the US, they have been lending to borrowers who are known as NINJAs – No Income, No Jobs, No Assets.
4. Loan to Value Ratio (“LVR”)    Generally, the LVR that Australian banks apply is 65%, up to a maximum of 80%. In the US, LVRs frequently exceed 80% and can be as high as 140%.
5. Honeymoon Rates or Reset Clauses    Australain home loans do not use any borrower ‘reset clauses’ with deep discounts causing repayment shock to borrowers. Some Australian Lenders offer to some borrowers a Honeymoon Rate loan which is currently only 1.5% below the standard rate and is limited to the first 6 to 12 months of the loan. But a compelling difference is the borrowers repayment capacity is tested on the full interest rate rather than the discounted or honeymoon rate. We find therefore that borrowers are more than able to cope with this increase in interest rates at the end of the honeymoon period. In the US, borrowers were assessed on the lower discount rate and the discounts were often 3% for the first two years (a much longer discount rate than Australia). After 2 years, the rate increased substantially. These loans are known as “2/28” loans, where the first 2 years was on the discount rate and the next 28 years were on the much higher rate.
6. The proportion of loans that are sub-prime   The proportion of loans in Australia that are sub-prime remains very low, in the order of 1-2% of all mortgages in Australia. In the US, the sub-prime mortgage market constitutes 17% (up from 4% in 2003) of the current US mortgage market.
7. Delinquency rates are very low in Australia    Mortgage delinquency rates in Australia still remain very low. According to a recent Moody’s report on the Australian residential mortgage market, delinquency rates, defined as mortgages 30 days past due, for all mortgages are currently at 1.26% for “full doc” lending and 2.03% for “low doc” lending. In the US, sub prime 30 day past due rates are currently 9.45%.
8. Recourse to the borrower    Lenders in Australia have direct recourse against the borrower in the event of a default of the loan. Lenders can obtain legal orders to declare the borrower bankrupt and seize other assets belonging to the borrower to recover any shortfall. In the US, significant difficulties exist to prevent lenders obtaining the bankruptcy of borrowers and many mortgages do not have personal covenants allowing lenders to proceed directly against borrowers and their assets.

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