Subprime lending and the stock market rout

Escrito el 12 marzo 2007 por Juan Toro en Financial Markets

Subprime mortgages and carry trades have been the two nasty words surrounding the recent sell off in the financial markets. The panic was not coming so much on the fall of the Chinese stock market but on the fact that an increase in risk aversion could have ugly consequences in the credit and the foreign exchange market.

But why the subprime mortgages market mattered for Wall Street?. To explain this we need to understand a bit this market. Subprime mortgages are used by someone that cannot qualify for prime financing. Subprime mortgages take approximately 15 % of all mortgages in the US. According to Standard & Poors, «probably the gain in home ownership over the last four, five years, is almost entirely due to looser lending standards.» This market generally targets people with bad or nor credit history, the least creditworthy tier. The development of this market has made mortgages available to those that otherwise would have had no access to the mortgages market. In compensation, borrowers get charged much higher rates. In the last three years the standards used to qualify for sub-prime borrowing have been lowered and other possibilities have been offered to borrowers: such as interest rates only and hybrid mortgages. Hybrid mortgages take many forms. One of them in the 2/28 ARMS This is an adjustable mortgage were the rate is fixed for the first two years and reset in the third at a pre-known level index plus a large margin that can go above the 6 %. This delays problems into the future. Actually most of these types of mortgages were written in 2004 and 2005 and the jump in rates is kicking in.

Sub-prime mortgage lenders have been hit recently by late payments that have turned many of them into trouble. If the percentage of late payments was 7 % a year ago it is now well above 12 %. The numbers of lenders facing financing stretch has increased. Fremont General and New Century are a few examples. Probably this tells you little as you have never heard of them. Do not worry, more relevant players are affected. HSBC has written off around 10 billions dollars in bad loan subprime related and GMAC Financial Service, a subsidiary from General Motors is also cleaning its books.

Some people argue that this is a well separated market and that any credit problem there should not spread elsewhere. Wrong. It all matters. It matters the reassessment of risk by the market. Even if you are a prime borrower you are going to see higher prices in your mortgage. Goldman says that tighter lending standards could cut new home demand by 20% of last year’s demand. It also matters how these mortgages have been repackaged and who holds them. These mortgages are generally packaged as securitized -backed securities- and the middle men are Wall Street banks. These middle men


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