With the first quarter of 2008 behind it, the United States has started the clean-up effort in the wake of the sub-prime lending disaster. And it has a long way to go
Poor mortgage lending practices brought the United States – previously one of the world’s strongest economies – to its knees last year and the rescue operation is now in full swing.
The losses are still being tallied but tentative estimates are that US lenders stand to lose as much as US$400 billion ($427 billion), while global stock market losses are being totted up at around $US7.7 trillion ($8.2 trillion).
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Government intervention and a renewed focus on ‘best practice’ are helping to keep the US mortgage market afloat. But there are still plenty of challenges to be overcome before a recovery can even be hinted at.
The state of play
At the end of 2007 the weak underwriting habits of US lenders had created a glut of 7.2 million sub-prime loans in default, held by borrowers with little or no equity in their homes according to the Centre for Responsible Lending.
In the past, refinancing would have been the first course of action that lenders pursued but instead many jumped straight to foreclosure in a desperate attempt to recover their losses.
The effect has been startling, causing the US to witness the first national decline in property prices since the 1930s – and leaving the mortgage industry in a desperate position.
Recent estimates based on sub-prime mortgages foreclosed on in late 2007 have revealed total losses for lenders generally exceeded 50 per cent of the principal balance due on the loan – making foreclosure the least preferable option.
Since then, the lending industry has done an about-face. Now, its main priority is to keep borrowers in their homes and renegotiate loan terms or risk being saddled with hundreds of thousands of homes with rapidly declining values.
According to the Mortgage Bankers Association, over 300,000 borrowers had their loan terms modified or payment plans restructured during the fourth quarter of 2007.
The US government has also been doing its bit to help reduce foreclosure rates by rolling out several initiatives targeted at the estimated 2.8 million mortgage holders expected to default throughout 2008 and 2009. These initiatives include the Federal Housing Administration’s Secure program and the HOPE NOW scheme, which has frozen interest rates for qualifying borrowers for the next five years.
The US Federal Reserve (Fed) also dropped interest rates by a massive 75 basis points in March in an effort to reduce the stress on borrowers.
Credit going cheap
But while these initiatives are providing a solid supporting framework for borrowers and lenders as they struggle to keep their heads above water, they have also created an unfortunate Catch 22 scenario for investors in the capital markets.
Declining property values and a lack of confidence in lending practices has seen credit risk spreads widen and volatility in the financial markets increase, putting a stop on lenders’ ability to access reasonably priced credit, for the time being at least.
The cost of credit and the level of interest from capital market investors frightened off by last year’s losses will be fundamental to the sector’s recovery.
For lenders, the most immediate concern is to find buyers for the leveraged buy-out (LBO) debt they currently have on their books.
Many US lenders chose to access the private equity markets to initially fund LBO loans with the intention of transferring them to the secondary (or capital) markets after a short period of time.
In February, Standard and Poor’s estimated that US lenders were waiting to sell over $148 billion ($158 billion) worth of LBO debt. But with no buyers interested, lenders will be forced to make further provisions for the debt they are holding or to accept current lower market prices.
As well as trying to source buyers, lenders will also need to focus on generating new business to see them through the current turmoil.
The US mortgage market is valued at an estimated US$11 trillion ($11.7 trillion) – and at least US$1 trillion ($1.07 trillion) in new investments will need to be injected if the cost of funding is to improve.
While the industry continues its efforts to attract investors back to the capital markets, the Fed has made billions of dollars available to institutions along with several foreign central banks.
The Fed is also offering major financial institutions a 28-day “repurchase agreement” where they will temporarily hold their securities in exchange for cash. It is also expanding its term auction facilities, allowing lenders to put up collateral for cash in an attempt to inject liquidity to the markets.
But the Fed’s actions are failing to spur investors into immediate action and the slow pace of business has led many lenders to significantly downsize their operations in a bid to keep expenditures low.
As lenders struggle to cope with mounting losses and the prospect of even higher funding costs, distribution models are being ruthlessly revised, particularly by those who use broker channels.
Channels under scrutiny
Before the sub-prime crisis hit, lenders relied heavily on the broker channel. Its commission-based fee structure established brokers as a hard-working and low-cost way of marketing home loans.
But in these difficult times, the broker channel is now being seen as a costly and expendable arm – particularly for the wholesale sector.
By the end of 2007, at least 26,000 mortgage brokers had been forced to the wall, with predictions that a further 130,000 of the nation’s estimated 400,000 brokers could go under before the crisis is over.
According to US broker web news provider Broker Universe, half of the top 42 wholesale lenders in the US have either stopped dealing with brokers or have exited wholesale distribution altogether since the onset of the sub-prime crisis – including giants like Bank of America.
The reputation of the broker channel has also been severely damaged by the poor underwriting practices associated with the sub-prime crisis and wary consumers and investors are searching for a scapegoat to blame for the nation’s financial meltdown.
A Bill has been proposed which will introduce a national broker registry with the hope of regenerating confidence in the broker channel. But it could be too little too late for the sector which may struggle to find a place in the lending future of the US.
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THE OUTLOOK DOWN UNDER
The future for the US is grim but how will Australia fare?
The US economy is still considered to be the most important in the world, giving rise to the adage ‘if the US sneezes the world catches a cold’.
But with Australia’s financial security linked to many other global financial markets, commentators predict the impact of the sub-prime crisis will be less severe here than in the US.
According to Fariborz Moshirian, a Professor of Finance at the University of New South Wales, the US housing and credit squeeze will continue to impact the financial markets in Europe and Asia but the economic outlook for growth in Australia will remain robust.
“Our economy is linked to China, India, Korea and other Asian countries where we’re still seeing strong economic growth,” says Mr Moshirian.
According to Mr Moshirian, demand for credit will be closely linked to the cost of funding in 2008 and the Australian mortgage market is likely to experience only a minor downturn.
“Strong exports of raw materials, agriculture products and tax cuts in July will ensure that the Australian economy will not experience a drastic slowdown in the foreseeable future.”
State of the market
Figure Fact
241 Number of US lenders that have disappeared as a result of the sub-prime meltdown
US$300 billion Value of loans due to reset at higher interest rates this year
2.1 million Number of loans due to reset at higher interest rates this year
$200 billion Amount injected into the capital markets in March to help rescue lenders
2 per cent The current interest rate set by the US Federal Reserve
