Sub Prime Mortgage Information - Foreclosure News

The saga of sub-prime mortgage muddle
Assessing the impact of this worldwide financial contagion will take months, if not years
The main reasons for the financial mess seem to be the accretion of large funds with U.S. banks and the structured products developed to pass on the risk to investors.

A home is advertised for sale at a foreclosure auction in Pasadena, California, U.S., last month. The number of homeowners receiving foreclosure notices hit a record high during spring, driven up by problems with sub-prime mortgages.

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” so said Warren Buffett, reportedly the third richest person in the world, in 2002. His prophetic words are becoming true with the unravelling of the financial mess created by the sub-prime lending spree in the U.S. The developments will also affect emerging market countries such as India. The developments that led to the explosive situation are traced here.

Sub-prime loans are those given to borrowers whose creditworthiness is below prime and hence are of low quality. In India, sub-prime lending refers to loans carrying rates below the prime lending rate normally offered to high quality borrowers.

Sub-prime or low quality loans are mainly of three kinds: car loans, credit card loans and house mortgage loans. Of these, the biggest and the ones that can endanger the entire financial system are the house mortgage loans. These formed nearly one fifth of all U.S. mortgage loans in 2006, going up from 9 per cent till 2004.Risky home loans

The sub-prime loans were given to borrowers who did not have the capacity to service them (pay interest and repay principal). At the height of such lending, it was said, the borrowers were in the NINJA (no income, no jobs also) category. To lure such borrowers, some lenders adopted ‘predatory’ practices. They lent deliberately knowing that there will be default and, when it occurred, seized the houses mortgaged and sold them off to make a profit.

The basic question is why would any lender (apart from the predatory ones) give loans that carried the highest risk. One reason is that these carried higher interest rates. But, the main reasons seem to be two: large surplus funds with banks and the introduction of esoteric financial instruments that passed on the risk to unsuspecting investors.

Soon after the dotcom bubble burst in 2002, the Federal Reserve (central bank) of the U.S. pumped in money into the system. Too much money in the system led inevitably to lower quality of lending. The availability of credit derivative instruments, which basically transferred the risk to another party, accelerated the pace of sub-prime lending.

Typically, a bank or mortgage finance company (many of them owned by banks) lent to a sub-prime borrower to finance purchase of a house. Since the borrower did not have the means to even pay interest in the beginning, the lender sugar-coated the loan through an adjusted rate mortgage (ARM). One type of such a loan was called 2-28. During the first two years of a 30-year mortgage loan, interest was pegged at a low fixed rate of 4 per cent. In the subsequent 28 years, the rate was floating (variable) at around 5 per cent over a benchmark rate such as LIBOR (London Inter-Bank Offered Rate). Flawed assumption

The lender hoped that even if the borrower could not service the loan after two years, he/she could always take refinance (raise a fresh loan against the same house) for a larger amount. Implicit in this was the assumption that house prices will go on increasing. This premise got a jolt when house prices started climbing down after peaking in 2005-06. When the first two years expired, the interest rate also moved up to very high levels. With LIBOR ruling at over 5 per cent, the mortgage rate shot up to 10 per cent. Suddenly, the EMI (equated monthly installment) of such a loan nearly doubled: for a Rs. 5 lakh loan, it is Rs. 4,470 a month for a 28-year, 10 per cent loan, against Rs. 2,400 for a 30- year 4 per cent loan.

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