up home page bottom

Tuesday, March 4, 2008

Sub-prime Mortgage Problems in US

As I am gathering some information to write a post on US recession, I am across a TV report on US sub-prime mortgage meltdown on 60 minutes. We have seen how this problem is spreading to the rest of the world.

The chart shows that with the sub-prime model, there are incentives to cheat the money-lending system. What is happening is that mortgage loans are given to home-buyers whose repayment ability is questionable. Normally the loans only require them to initially pay with low interest rate. The home-buyers are convinced that home properties will go up in price because of the property boom time. The banks then repackage the mortgage securities and sell them at the bond market as high quality securities. Some of the folks who buy these bonds are the pension funds, foreign investors etc.

It appeared to be a win-win situation for everyone involved. In fact, you may even be paid to buy a house! Now the situation has reversed. Property prices are plummeting and the home-owners are unable to pay their mortgages. The low interest payment period is over and suddenly the home-owners find that they are stuck with high interest payment. They find that the mortgage value is higher than the price of their house. It made more sense for them to just walk away from the debts.

Meanwhile, the value of the mortgage-back securities in the bond market plunges. The banks have to write-down hundreds of millions of dollars as they were unable to collect payment from the home-buyers. There are two types of bonds i.e. insured and uninsured. Insured bonds are normally more popular because they are perceived as safer investment. Insured bonds are insured by bond insurers such as MBIA and AMBAC, the largest and second largest bond insurers in US respectively. These bond insurers are given some kind of rating (AAA, AA etc.) by rating agencies such as Moody's, Standard & Poor etc. As a result of the insured bond defaults, the bond insurers are forced to come up with their insurance claims payment. Their inability to do so is causing their ratings to be lowered by the agencies. The result of this is that banks no longer see value in insured bonds and sometimes the uninsured bonds are higher priced than insured bonds (see post).

With nobody bailing the bond insurers, I think we will be seeing a bigger financial crisis. Warren Buffet, initially looked into helping with the municipal bonds, now is pulling out (see here).

As of today, the property prices around our neighborhood has fallen between 20-30%, which is at the year 2004 price level. It is projected that the prices will continue to slide (another 20%) well into 2003 levels by September 2009.

Click here to watch 60 minutes video on the sub-prime mess.

Good links: Mish's Blog, BBC article, LA times