Why the US subprime lending spree could end in tears

Subprime mortgage loans have boomed in the US, but the bursting of America's housing bubble now threatens major repercussions for financial markets. How far will the rot spread?

Subprime mortgage loans have boomed in the US, but the bursting of America's housing bubble now threatens major repercussions for financial markets. Eoin Gleeson reports

What are subprime mortgages?

Subprime mortgages are loans to people with poor, or limited, credit records, or already high debt levels. The rates on these loans are typically 2%-3% above those on safer (or prime) loans. This compensates the lender for taking the added risk. Along with house prices, subprime loans in the US have soared from around $100bn-worth six years ago to more than $800bn in 2006. About a fifth of all new mortgages in the US last year were sub-prime, and they account for around 13.5% of outstanding home loans, according to the Mortgage Bankers Association.

Isn't this irresponsible of lenders?

Not necessarily. When house prices are rising, as they have been in the US until recently, its hard for them to lose money in subprime: if a borrower gets into trouble, they can just remortgage to keep up with payments, or simply sell the house. Subprime lending is also more lucrative as well as getting extra interest, the lenders have been able to charge hefty arrangement fees. And just in case the loans do run into trouble, they have also been selling on their risk: their loans have been packaged into bond-type structures called mortgage-backed securities (MBSs) and then sold on to investors such as hedge funds and pension funds. This way, mortgage lenders offload their risk, while investors in MBSs get a higher interest payment than they would receive from a corporate bond with a comparable credit rating. (By parcelling a bundle of mortgages together, you decrease the impact of individual homeowners defaulting and can therefore get a better credit rating for the bundle than you could for one mortgage alone.)

So what's the problem?

As the US housing market slowed last year and the number of buyers fell, lenders relaxed their lending standards even further accepting loan applications without checking people's incomes and selling larger numbers of new products. Many subprime loans were taken out under deals that offered a very low starting rate of interest, but then reset after a couple of years to a far higher rate, for example. These initially got the buyers in the door, but now, as the higher rates kick in, the same buyers are struggling. Worse, now that house prices have started falling, they can't sell up or refinance their way out of difficulty. The result is that more subprime loans are going bad more quickly than lenders expected: 12.6% were in arrears in the last quarter of 2006.

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What does this mean for lenders?

Even during the recent period of buoyant house prices, the level of subprime foreclosures was high, with as many as one in eight loans ending in foreclosure within five years. But now that house prices are falling, it's getting worse. One in five mortgages taken out by high-risk creditors in the US in the past two years is expected to end in repossession.The problem for sub-prime lenders is that although they have sold off their loans as MBSs, these loans have a clause in them that stipulates that "if they deteriorate too far, too quickly they can be returned to the originator", says Felix Salmon on the Roubini Global Economics blog. And they are being returned. MBS investors are sending as many loans back as possible.

At the same time, the banks are cutting off the subprime lenders' credit lines, leaving them with hefty debts and no money for new loans. Twenty two subprime lenders have gone to the wall in the last two months alone.

How can we measure the extent of the problem?

One way to measure the effects of problems in the subprime mortgage sector is to look at the Credit Default Swaps (CDS) market. A CDS effectively insures against a debt going bad, so if we check the CDS market, we can get a view of the perceived risk in the subprime market. In the last few months, the cost of insuring against the default of an MBS based on the lowest grade (ie, the most risky) of subprime loans (these are graded BBB- by lenders) has more than quadrupled and the index that measures the change in the cost (the ABX) has moved by 30% since the

end of January alone. Worryingly, the lack of faith in loans among investors is now spreading to mortgages in the mid-range of credit quality: the Alt-A, or alternative A-rated paper. These loans are not subprime, but tend to have higher levels of debt secured against the property than prime' mortgages. Standard & Poor's have included Alt-A paper in 18 classes of securities from 11 residential mortgage pools that are on watch for

a downgrade.

How far will the subprime rot spread?

The expected jump in foreclosures could deprive two million people of their homes, says Tom Bawden in The Times. But the big worry is that concerns about credit risk in the subprime sector will cause lenders to tighten lending criteria across the scale even further. This would hurt the housing market more, allowing fewer new borrowers into the market, putting the breaks on refinancing the only way many people are currently keeping their heads above water, and forcing further repossessions. As for the MBS market, according to Joshua Rosner of Graham Fisher & Co, co-author of a study on the market, "The danger in these products is that in changing hands so many times, no one knows their true make-up, and thus who is holding the risk." But as the current problems show, these risks are much more significant than the broader markets had anticipated.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.