Commercial Insurance Articles
What happened in the US sub-prime mortgage market and could it happen here?
31 May 2007
America has set the world's financial agenda for much of the past century, so when it underwent upheaval after the collapse of sub-prime mortgages the world sat up and started asking questions.
Could it be shades of 1987? Or even 1929? Could a crash still be on the cards? And could it spread to the UK?
No definitive answers have appeared, although the economic situation for the US does not appear to be as severe as reaching an all-out stock market crash.
Wall Street did, however, suffer its biggest weekly fall for four years with the Dow Jones industrial average taking a 4.2 per cent hit, showing that the sub-prime collapse gave the US economy a real shock.
The roots of the problem stemmed from lenders' willingness to provide mortgages to customers with poor credit histories.
These sub-prime mortgages offer those people a helpful chance to enter the housing market, but the products feature adjustable rates which can rise quickly during the course of the loan.
If market conditions force interest rates up or house prices down, there is a high risk of foreclosure on the mortgage as the mortgage holder cannot pay up and has no equity to support refinancing.
Although these factors are meant to be taken into account by lenders, the larger-scale economic problems like competition from the Euro zone, the massive current account deficit in the US and rumours that the Bank of China was to sell off its dollar reserves made conditions in the US at the start of 2007 unfavourable.
Due to this, foreclosures reached a 37-year high, while the US Centre for Responsible Lending estimated that 20 per cent of all sub-prime mortgages in the previous two years could be defaulted – leading to 600,000 extra homes flooding the market.
When American banks realised they were risking losing billions of dollars through these bad loans, they put pressure on lenders to re-purchase the deals.
This led lenders like New Century, one of the largest dealers in sub-prime mortgages in the US, to file for bankruptcy to protect themselves from their creditors while also cutting 3,200 jobs – more than half of its workforce.
International banks like Barclays and HSBC were affected by the losses in mortgage payments, either directly or through backing sub-prime lenders, which led to some issuing profit warnings in the first quarter of this year.
Such was the hit taken by HSBC that its US arm made available provisions of $1.7 billion to cover the possible credit losses - almost double the cover put aside a year earlier.
The breakdown of sub-prime led to Americans in debt trying to offload their property as quickly as possible, which the market could not absorb – causing house prices to fall as property was not finding a buyer.
Last month, Jonathan Davis a chartered financial planner and spokesman for housepricecrash.co.uk told the BBC: "Prices are falling faster in the US than at any time in history.
"This is already slowing US growth and will inevitably hit the UK as well."
Fears that the recession in the US housing market could spread into other sectors of the economy were based on America's reliance on its high consumer demand to continue its economic growth after losing ground to China and Asia in manufacturing.
If house prices dropped and caused a fall in Americans' goods consumption, it could have a knock-on effect on both the US and world economy.
"When the US catches a cold we tend to catch one as well," explained Mr Davis at the time.
However, over a month later and it seems this scenario has been avoided and the UK's housing market remains relatively sniffle-free, although recent reports suggest prices starting to fall in many postcode areas in the UK.
Although the US slump continues, any slight curbing of the market is more attributable to the Bank of England's interest rate rises to counter inflation than the goings on across the Atlantic, so does this show the UK property market has grown strong enough to withstand outside influence?
The biggest buffer against any downturn in the property market remains the high demand, which in London can see 80 to 100 people chasing the same purchase and so keeps house prices high.
But, in addition, there remains confidence in the sub-prime market in the UK, despite the difficulties in the US, as lenders have erred on the side of caution.
"There has been some of the loosening of mortgage lending criteria but nothing like the US," said Ray Boulger, technical director of mortgage broker Charcol.
"People are able to get 100 per cent mortgages or borrow four or five times their income but lenders have not offered the two together."
In this way, UK banks have kept up more barriers against negative equity in sub-prime mortgages – helping to ensure that defaults remain low and keep the creditors happy in a still-growing market.
Could a US-style sub-prime collapse hit the UK?
Analyst Brian Durrant believes it to be unlikely, unless sup-prime lenders target homeowners that could be at greater risk of foreclosing. Unfortunately, these people are those who are most likely to sign up to a sub-prime mortgage deal.
Writing for the Daily Reckoning, Mr Durrant pointed out that high demand exists in most areas of the UK, but not all.
"Properties in unattractive areas with weak local economies and homeowners who are in the equivalent of the US sub-prime category are the most vulnerable," he said.
However, he added: "A slump prompting a serious rise in unemployment is not an imminent threat.
