Download Study on Prevention of the American Sub-prime Mortgage Loan Risk

Study on Prevention of the American Sub-prime Mortgage Loan Risk
and Spread
QU Fenggeng
Henan Institute of Finance and Economics, P. R. China.450002
[email protected]
Abstract: It cannot be ignored that American sub-prime mortgage loan wave has a big influence on the
international economy and finance, although the effect of sub-prime mortgage loan wave mainly focus
on America and Europe, it may spread to other areas through such channels as its extensive investors
and derivatives as well as affection on the market expectation and the operation of real economy. The
rising trend of global risk premium may also bring regulative pressure on the asset prices, and once there
is a regulation on price, the bank credit security may be affected. Therefore, close attention should be
paid to the influence of American sub-prime mortgage loan market on international financial market and
possible impact on international economy. There needs to adopt measures to strengthen risk prevention
and ensure financial and economic security.
Key words: Sub-prime mortgage, financial crisis, risk prevention
0 Foreword
Since the late March in 2007, the effect of the American sub-prime mortgage loan market crisis on
the global stock market has upgraded step by step, and the American stock crashed and dragged the
Asian stock market to slump generally, spreading to the global financial market, which caused a number
of companies to go bankrupt one after another, and brought severe loss to investment institutions, such
as investment fund. American economy plays a decisive role in the global economy; its trends would
generate far-reaching effect on the global economy, and the spread of its risks and chain reactions need
people’s enough attention.
1. Formation of American sub-prime mortgage loan
1.1 Connotation of American sub-prime mortgage loan
The sub-prime and prime in American mortgage loan market is divided by the credit conditions of
the borrowers. According to the credit level of borrowers, lending institutions treat the borrowers
differently, thus, formed two-level market. Those who cannot get a prime loan for low credit can only
seek for the loan in the sub-prime market.
For lending institutions, sub-prime loan is a high-return business. But compared with prime loan,
sub-prime loan requires lower credit degree of the borrower, so credit records of borrowers are relatively
poor, and then the risks faced by sub-prime loan institutions are also higher naturally. The study data of
UBS indicated that, by the end of 2006, the repayment default rate in America sub-prime mortgage loan
market reached up to 10.5%, which was as 7 times as that of prime loan market.
For those borrowers, their default will enhance the refinancing difficulty and lead to foreclosure of
the pledge, unable to enjoy the interests of the house price rising. Furthermore, the default of any
borrower would also generate a bad influence on the residential areas. According to a survey from
Chicago, if there is one defaulting foreclosure in a block, the average value of the detached single
residence in this block will fall by 10 , moreover, if there is some relatively concentrated default in a
block, the credibility of this area will be severely reduced.
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1.2 Development of American sub-prime mortgage loan market
First, Depository Institutions Deregulation and Monetary Control Act (DID MCA) of 1980 had
canceled the interest rate cap specified by Regulation Q of Federal Reserve (FED). Alternative
Mortgage Transactions Parity Act of 1982 had allowed the use of variable interest rate. Tax Reform Act
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of 1986 had prohibited tax-exempt for the interest of consumption loans. All these acts provided a
favorable legal environment for sub-prime mortgage loan market.
Secondly, the interest rate continued to go down since the late 1990s, and refinancing by the way of
cash outflow came into fashion. Borrowers continuously borrowed new debt to repay dead horse, and
the amount of new debt would exceed the original debts. When the house price rises constantly, this
method could make the borrower obtain the new capital source continuously, thus increase the demand
for the sub-prime mortgage loan.
Finally, various changes successively occurred in the market also provide a favorable condition for
development of the sub-prime mortgage loan. For example, in the early 1990s, the demand for the
standard mortgage loan reduced owing to the rise in interest rates, so mortgage brokers began to pay
more attention to the sub-prime mortgage loan market. And the rise of assets securitization also provides
a good opportunity for the sub-prime mortgage loan market in the middle of 1990s.
Since the house price rose and interest rate went down continuously to the lowest point in recent 40
years, the cost of real estate investment has been reduced. When the house price keeps rising
continuously, the borrower can also obtain refinancing through rise in value of house property to fill the
gap, even though their cash flow is not enough to repay the loan. Therefore, the sub-prime mortgage
loan began a new round of increase by the end of 1990s, until the break out of the crisis today.
2. Reasons of the crisis of the American sub-prime mortgage loan
The starting point of the American sub-prime mortgage loan is good, and it has attained obvious
effect in the first ten years. From 1994 to 2006, the American house ownership rate has risen to
69%from 64%, and more than 9 million families have owned houses in this period. But the high risk of
sub-prime mortgage loan has gone along with its quick availability. Compared with the interest rate of
common mortgage loan of 6%-8%, that of sub-prime mortgage loan may reach up to 10%-12%, and
most of the sub-prime mortgage loans took the form of ARM, the repayment rate of sub-prime mortgage
loan became higher and higher as FED raised interest rate for many times, which caused the rising of
default rate and foreclosure rate and finally led to the crisis today.
2.1 Lending impulse
From 2001 to 2004, FED has stimulated the development of estate industry through the policy of
low interest rate. The ardor of buying houses of the American heated up continuously, and the sub-prime
mortgage loan became the choice of the buyers whose credit condition could not meet the requirement
of the prime loan.
The intense competition among the lending institutions has given birth to the diversity of high risk
sub-prime mortgage loan. Some lending institutions have even promoted the loan of “zero down
payment”. The loose loan qualification verification became the important driving force unprecedented
actively in the real estate trading market, but also has planted the seed of crisis. These new products
were fashionable for a time. One aspect of the reasons was that the borrowers underestimated the
potential risk for continuous prosperity of housing market; the other was that the risk control of lending
institutions was not powerful, and the lending institutions only focused on promoting these products
vigorously owing to intensifying competition, but intentionally neglect the step of explaining the risk to
the borrower and confirming the repayment capability of borrower. The data of FED indicated that the
percent of the sub-prime loan in total housing mortgage loans rose to 20% in 2006 from 5%.
Because the FED has raised the interest rate for 17 times successively, the housing market has
cooled continually, it was very difficult for the borrowers to sell their own house, and the house value
may also fall to the degree that it was not enough to repay the rest loan even if it can be sold out, which
led to overdue repayment and foreclosure of the pledge, and brought pessimistic expectation to the
sub-prime mortgage loan. And then the sub-prime market may shake seriously, and the fund chain of
loan market may be impacted, and then the whole mortgage loan market may also be affected. The
property market price may continue to decline because of the stop-loss psychology of house owner. The
superimposition of twofold factors formed the Matthew Effect, bringing the vicious circle and
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intensifying the sub-prime market crisis.
2.2 “Predatory” lending
Driven by the huge interest, in order to make more commission, there appear many bad acts in the
sub-prime loan market, which includes two kinds roughly:
Predatory lending: The lending institutions or its agent have not disclosed to consumers truly and
thoroughly about the complicated information related to lending terms and interest rate risk according to
relevant regulations of American law. In this kind of case, the victim is the consumer usually.
Mortgage fraud: The victim is lending institution generally in the loan fraud crime acted by the
professional criminals. In recent years, the leading type of loan in sub-prime loan market is mixed type
ARM, the rate of which was fixed in the first two years and then increased once every half year. Usually
it was raised by much range, and many loaners can not afford the monthly payment, so they have to
refund with a higher cost, sell out the houses, or stop repayment. The basis of making these loans by the
leading institution rests on the property value, but not repayment capability of borrowers.
2.3 Absence of supervision
The reason for the housing loan market crisis is the supervision absence of the American finance
supervision department. At the end of 2003, the finance supervisor noticed that the credit standard went
down for the first time, and at that time, the Fitch Ratings has already added one of the main sub-prime
housing mortgage loan institution into the list of “Credit Watch”, expressing the worry to the sub-prime
housing mortgage operation of this institution. The data collected by FED Board of Governors definitely
implied that lending institution would start to lower the loan standards at the beginning of 2004. In spite
of the existence of these early-warning singles, it seemed that the leadership of FED was encouraging
the exploitation and application of ARM in Feb. 2004, however, it is this kind of loans that present
countless bad debts today, which leads to foreclosure of the pledge of borrower. In the meantime, FED
constantly raises the interest rate on one hand, but kept on encouraging the lending institutions on the
exploitation and sales of ARM on the other hand. It is this self-contradictory behavior that creates the
current storm which sweeps millions of American homeowners.
3. Analysis on risk spread of American sub-prime mortgage loan crisis
The American sub-prime mortgage loan crisis has spread to financial market, and global security
and financial markets have produced reaction of different degrees.
3.1 Cooling down of American property market makes the prospect of American economic growth
bleaker
As the American property market cools down, many institutions engaged in sub-prime mortgage
loan are forced to liquidate, and the anxiety of investors over the potential financial risk suddenly heats
up, which also makes the prospect of American economic growth bleaker. Since the investors
anticipated that American economy would remain downturn, the dollar suffers sharp decline against the
Euro, Pound and even the Yen, and against the Euro, it refurbishes historical low point again. The crisis
of sub-prime mortgage loan, which is a high-risk field, also appears gradually.
3.2 American sub-prime mortgage loan crisis involves numerous subjects, and affects in relatively
more extensive ranges
From the view of the financial subject, first, numerous institutions engaged in sub-prime mortgage
loan are forced to stop business or close down; secondly, the companies which hold the sub-prime
mortgage loan (including securitization) assets, including mutual funds, hedge funds, large banks,
insurance companies, etc., are faced with assets loss of serious devaluation; thirdly, “contagion effect”,
the shutdown or loss of related finance institution of sub-prime mortgage loan has further caused such
final loaners as banks to tighten credit loan quickly, which affected the operation of financial industry
and even the prosperity degree of whole economy, fourthly, “the effect of sheep flock”, the closure or
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loss of related financial institutions of sub-prime mortgage loan may produce a chain reaction and give
rise to greater financial crisis.
Seen from the financial market, first, the sub-prime mortgage crisis may lead to further credit
tightening of the real estate, and it may cause the American housing market to decline continually if the
inventory pressure of real estate increases further; secondly, the problems of sub-prime mortgage loan
have made the global investors worry about American real estate and financial industry, which has
caused the continuous depreciation of American stock market; thirdly, the two problems above may
further cause American economy to cool down, which may affect the global economic growth; fourthly,
the uncertainty of the American finance and economical development may raise violent fluctuations on
the assets prices of global stock market, foreign exchange market, gold, crude oil, copper and so on.
3.3 Impact of American sub-prime mortgage loan crisis on the international insurance industry
In the business chains of the sub-prime mortgage loan, the insurance companies are the main
buyers of various products of the sub-prime mortgage loan bonds, so the international insurance industry
suffered from it. Some data indicates that, by the end of 2006, the American insurance companies
accounted for 19% of investment on American sub-prime mortgage loan. At present, in the portfolio of
the American life insurance companies, Prudential Financial takes the highest rate (13.8%) of high-risk
assets [2], Metlife follows it closely (13.6%), Genworth Financial ranks the third (9%). The statistics
show that high-risk assets accounts for 7.8% averagely in the assets of 15 listed life insurance
companies in America. In Europe, Finance Times of UK reported that the crisis of American sub-prime
mortgage loan had spread to insurance market in Lloyd’s of London. Beazley Insurance Company, a
member of Lloyd’s, recently asserted that it could hardly count the investment amount in the sub-prime
mortgage loan market, but it was forecasted that it would not affect its return on investment on
sub-prime mortgage loan bonds.
3.4 Impact of American sub-prime mortgage loan crisis spread
From the aspect of profit comparison relationship, generally speaking, the sub-prime mortgage loan
problem can cause the fall of the related price of the stock and securities assets with high credit risk
more easily; in the stock market, the financial and the construction stocks suffer the greatest influence.
And the financial products, such as state bonds, whose credit level is relatively high, may be benefited in
the situation of excluding the risk of interest rate being raised, and the demand may increase greatly.
From the aspect of subsequent trend, the impact of American sub-prime mortgage loan crisis may
continue for a time, and the problem of sub-prime mortgage loan may spread to the common housing
loan market.
The problem of sub-prime mortgage loan has been a hot issue in the international market. It is just
the problem of low-end customer market, whose influence on the main trend of American real estate is
limited, and it is also not very possible to cause the substantial transformation or turbulence of American
economy or finance. At present, the profit growth of American corporation comes to the highest point in
history. In order to protect the confidence in the world credit loan market and prevent tightening of
liquidity from leading to financial crisis, the capital injection sum of the central banks around the world
have already surpassed USD 326.2 billion, so it is not likely to arouse substantial transformation of the
world entire economy as long as the rate of unemployment and interest do not rise greatly. While the
securitization process of housing mortgage loan of emerging market is slow, it is difficult to spread the
market risk, so it is inevitable to bring financial storm in case of being impacted.
4. Precautionary measure against American sub-prime mortgage loan crisis
spread
The outbreak of American sub-prime mortgage loan crisis exerted serious influence on the
development trend of American economy and the international financial market. To prevent the birth of
the international financial crisis, the financial regulators must enhance financial supervision and
improve the operational ability of crisis control.
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4.1 Attach importance to the supervision and pre-alarming of housing credit loan crisis
The financial regulators shall closely supervise the economic operation of real estate credit loan
market, and watch out the accumulation of housing credit crisis factors; especially before the crisis
comes, the regulators shall send alarming signs to relevant economic departments for the government
and market participants to take precautions before it is too late, so as to avoid the fluster when the crisis
comes.
4.2 Attach importance to confidence recovery to financial market
Market confidence is the basis of financial asset value operation. When the financial crisis breaks
out, the crowds’ panic may be the promoter to enhance the impacting force of crisis. The inventors only
hope that they would suffer less loss in the disaster, and the result is that the individual rational behavior
will lead to the crowds’ irrational behavior, which will form great “effect of sheep flock”.
4.3 Protect the benefit of consumers at the bottom of individual housing credit loan market and
prevent the real estate market declining aggravatingly
Individual housing mortgage loan has its own unique characteristics, whose value in pledge has
positive relationship with loan issue quantity to a certain extent. Therefore, it is an important measure to
attach great importance to protecting the interests of individual consumers of housing credit loan for
guaranteeing the demands of real estate market and preventing the market from falling into vicious
circle, in order to reduce the cases of withdrawing house, settle down public mind, and prevent fast cool
of the consumption.
4.4 Improve market-protecting ability of large housing credit loan institution
Large credit loan institutions have relatively strong ability to resist risk and can protect and save the
market at the critical moment. They all have made rescue schemes and can “shoulder the responsibility”
to save the market, and then push it to European and emerging market with higher discount after
securitization.
4.5 Strength the utilization of risk-sharing effect of international financial market
Financial market is of global linkage. American sub-prime mortgage loan crisis will bring great
impact to world economy. Every country is not willing to see the situation; therefore, all governments
coordinate actively to contribute to the recovery of American sub-prime mortgage loan market.
4.6 Improve the quality of individual housing loan assets and strengthen the supervision of
individual housing credit loan to prevent risky loan happening
Establish and improve individual credit system and change the present situation that the credit
officers in the bank only judge and decide by original consulting materials like ID and personal income
certificate, as well as the condition of information inconsistence between the banks and clients, reduce
malicious falsehood behavior and strengthen the supervision and management of issued loans.
5. Conclusion.
We should pay close attention to the influence and possible impact of American sub-prime
mortgage loan market on international financial market, and take active measures to strengthen the risk
prevention work and ensure the financial security of China. First, we should monitor and control the
situation of crisis aggregation in housing mortgage loan market, send out warning to the loan lenders
and inventors before the outbreak of the crisis to reduce or stop new risky housing mortgage loan, and
limit the crisis spread in a certain range in the preliminary stage of the outbreak of market crisis to
prevent financial crisis spreading. Secondly, we should reassure the borrowers, reduce the property
assets taken back by banks and mortgage loan corporation to slow down the withdrawing speed, so as to
ensure the stabilization of housing price and prevent the crisis from spreading into social and political
fields. Thirdly, we should organize some strong financial organizations to shoulder the social
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responsibilities, buy the risky assets, and act in the market for long time to balance and spread risk.
Financial risk is a system risk, involving every field of the society, and it may spread to other areas
through such channels as its extensive investors and derivatives as well as its affection on the market
expectation and operation of real economy, and may affect the bank credit security. Therefore, the study
on preventing regional debt spread is quite necessary to ensure the stable operation of global financial
market.
References
[1] Compiled by Ning Wen, Han Yu, Zhu Li and Han Song. Episode of Crisis: The Evolution of the
Sub-prime Mortgage Market, Contemporary Financiers http://www.jrj.com . May 31, 2007
[2] Cao Honghui .The Sub-Prime Mortgage Loan Crisis Will Enlarge. http://www.jrj.com. Dec. 22,
2007
[3] Mei Xinyu.Market Reaction Magnifies Crisis of America Sub-prime Mortgage Loan. 21st Century
Business Herald. http://www.sina.com.cn. Aug. 7, 2007
[4] Ritschl·Sharma. Beware of Your Hands [America] News Weekly Jan. 7, 2008
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