Watch this BBC television report which explains the background to, and the causes of, the current sub-prime mortgage crisis :The US sub-prime mortgage crisis has
lead to plunging property prices, a slowdown in the US economy, and billions in losses by banks. It
stems from a fundamental change in the way mortgages are funded.
Click here to watch : BBC NEWS | Special Reports | creditcrunchRead the following text about the sub-prime crisis. What do the words and expressions in bold mean ?
Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do.
In recent years, banks have moved to a new model where they
sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing,
But it has also
led to abuses as banks no longer have the incentive to check carefully the
mortgages they issue.
In the past five years, the private sector has
dramatically expanded its role in the mortgage bond market, which had previously been dominated by government-sponsored agencies like Freddie Mac.
They specialised in new types of mortgages,
such as sub-prime lending to borrowers with poor credit histories and weak documentation of income, who were
shunned by the "prime" lenders like Freddie Mac.
They also included "jumbo" mortgages for properties over Freddie Mac's $417,000 (£202,000) mortgage limit.
The business
proved extremely profitable for the banks, which
earned a fee for each mortgage they sold on. They
urged mortgage brokers to sell more and more of these mortgages.
Now the mortgage bond market is
worth $6 trillion, and is the largest single part of the whole $27 trillion US bond market, bigger even than Treasury bonds.
For many years, Cleveland was the sub-prime capital of America.
It was a poor, working class city,
hit hard by the decline of manufacturing and
sharply divided along racial lines.
Mortgage brokers
focused their efforts by selling sub-prime mortgages in working class black areas where many people had
achieved home
ownership.
They told them that they could get cash by refinancing their homes, but often
neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate.
The result was
a wave of repossessions that
blighted neighbourhoods across the city and the inner suburbs.
By late 2007,
one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust,
acting on behalf of bondholders, was the largest property owner in the city.
Sub-prime lending had
spread from inner-city areas right
across America by 2005.
By then, one in five mortgages were sub-prime, and they were particularly popular
among recent immigrants trying to buy a home for the first time in the "hot" housing markets of Southern California, Arizona, Nevada, and the suburbs of Washington, DC and New York City.
House prices were high, and it was difficult to become an owner-occupier without moving to
the very edge of the metropolitan area.
But these mortgages had a much higher rate of repossession than conventional mortgages because they were adjustable rate mortgages (ARMs).
The payments were fixed for two years, and then became both higher and
dependent on the level of Fed intereset rates, which also
rose substantially.
Consequently, a wave of repossessions is
sweeping America as many of these mortgages reset to higher rates in the next two years.
And
it is likely that as many as two million families will be evicted from their homes as their cases
make their way through the courts.The Bush administration is
pushing the industry to renegotiate
rather than repossess where possible, but mortgage companies are being
overwhelmed by a tidal wave of cases.
The wave of repossessions is having a dramatic effect on house prices,
reversing the housing boom of the last few years and causing the first national decline in house prices since the 1930s.
There is
a glut of four million unsold homes that is
depressing prices, as builders have also been forced to lower prices
to get rid of unsold properties.
And house prices, which are
currently declining at an annual rate of 4.5%, are
expected to fall by at least 10% by next year - and more in areas like California and Florida which had the biggest
boom.
The property crash is also affecting
the broader economy, with the building industry expected
to cut its output by half, with the loss of between one and two million jobs.
Many smaller builders will
go out of business, and the larger firms are all
suffering huge losses.
The building industry
makes up 15% of the US economy, but
a slowdown in the property market also hits many other industries,
for instance makers of
durable goods, such as washing machines, and
DIY stores, such as Home Depot.
Economists expect the US economy to slow in the last three months of 2007 to an annual rate of 1% to 1.5%, compared with
growth of 3.9% now.
But no one is sure how long the slowdown will
last. Many US consumers have
spent beyond their current income by borrowing on credit, and the fall in the value of their homes may make them
reluctant to continue this
pattern in the future.
One reason the economic slowdown could get worse is that banks and other
lenders are
cutting back on how much credit they will make available.
They are rejecting more people who
apply for credit cards, insisting on bigger deposits for house purchase, and
looking more closely at applications for personal loans.
The mortgage market has been particularly badly affected, with individuals finding it very difficult to get non-traditional mortgages, both sub-prime and "jumbo" (over the limit guaranteed by government-sponsored agencies).
The banks have been forced to do this by
the drying up of
the wholesale bond markets and by the effect of the crisis on their own balance sheets.
The banking industry is facing huge losses as a result of the sub-prime crisis.
Already banks have announced
$60bn worth of losses as many of the mortgage bonds backed by sub-prime mortgages have
fallen in value.
The losses could be much greater, as many banks have
concealed their holdings of sub-prime mortgages in exotic,
off-balance sheet instruments such as "
structured investment vehicles" or SIVs.Although the banks say they do not own these SIVs, and
therefore are not
liable for their losses, they may be forced
to cover any bad debts that they accrue.
Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds.
These have
fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most
asset classes, even those considered safe by
the ratings agencies.
If the banks are forced
to reveal their losses based on current prices, they will be even bigger.
It is estimated that
ultimately losses suffered by financial institutions could be between $220bn and $450bn, as the $1 trillion in sub-prime mortgage bonds is revalued.
