SUBPRIME LENDING
- The first three quarters of 2007 has been marked by the
collapse of the subprime mortgage market in the United States. In the last few weeks of 2006, the poor credit quality of
that year's subprime lending came home to roost amid climbing interest rates
and slowing house price growth. The
brunt of the impact has taken place over the last ten months as dozens of firms have closed, and thousands have lost
their jobs. The subprime meltdown has
wreaked havoc across the financial markets.
- Assets backed by subprime mortgages were very
attractive to investors as they offered larger spreads that, with proper structuring,
would yield attractive margins. Given
the lucrative opportunities for investors, subprime mortgage-backed bonds
became very popular in CDOs (collateralized debt obligations). In recent years, up to
half of the collateral supporting these structured finance deals was
subprime-related. While CDOs ramped up
with subprime backed assets, other areas of the bond market had been at
historically low levels. The insatiable
demand for subprime mortgage assets caused originators to lower credit
standards in order to capitalize on the high margin business. In the late
stages of 2006, lending institutions, hedge fund investors and other mortgage
back security owners were vulnerable to aftereffects of the lax credit
standards.
- As homeowners’ ARM’s hit
their adjusted rate and the pursuant debt obligations became insurmountable,
defaults and foreclosures flooded the market, sending out a shock wave
throughout the housing industry and broader financial markets. Repossessions and a large supply of unsold
homes have saturated the housing market.
Falling demand and rising supply in the housing market have had a
negative impact on both housing starts and market prices, which are two primary
measures of how housing affects the economy as a whole.
- As a result of the
subprime collapse, the bond market saw spreads on mortgage-backed securities
and financial institutions widen dramatically.
The XSIF’s financial sector of the portfolio was hit the hardest (see
individual banks). Due to the uneasiness
of the market, XSIF was somewhat stuck in their position. Trading bonds of financial companies presented unique challenges
as it was not transparent what risks these companies had to subprime, bridge
loans, asset backed commercial paper, amongst other things. Furthermore, spreads of the financial
securities had widened to a point where further losses appeared relatively
minimal.
- XSIF acknowledges that the severity of the subprime
meltdown could lead the economy into a recession. The pinnacle of the subprime demand occurred
in late 2005 and 2006. Some analysts
believe that it will take years to realize the total effects of the subprime
meltdown. One forecast states that 1.1
million foreclosures will be filed in the next several years, reaching
approximately 13% of subprime originations or $326 billion in market
value. During the last housing slowdown
in the 1980s, interest rates were high.
The Fed was able to rectify the problem by lowering rates and thereby
pumping liquidity into the market.
However, in 2007, the housing market appears to be in somewhat of a
liquidity trap, meaning that the housing market has slowed during a period of low
interest rates. The combination of the
two renders monetary policy relatively impotent. To compound the issue, houses in some markets
have decreased in value and credit standards have tightened. When ARM hit their rate adjustment date,
fewer borrowers will be able to re-finance their debt as originators will take
a more conservative credit approach.