Saturday, July 5, 2008

Subprime Mortgage Crisis Explained (Unit 3)

Student’s question: The sub prime mortgage crisis has been around for a year but I still do not understand what is it actually? So why economy is slowing down?

It’s rather complicated, but I’ll try my best to make it comprehensive.

1. The sub-prime mortgage crisis originated from US. The term sub-prime lending itself means loans given out that do not meet certain official guidelines e.g. given to borrowers with poor credit history or low income

2. As such we say it is risky for both the borrowers & lenders. Default rate could be high due to the combination of high interest rates & poor credit background

3. But what is the rationale of issuing these mortgages knowing that it has high default rate? Those US mortgage lenders hoped that with the booming housing market that time, the mortgages will remain affordable

4. Furthermore mortgage brokers are paid handsomely for selling these mortgages & as such there will be great incentive to sell even more regardless of one’s credit ability

5. Mortgage companies then bundled these debts into consolidation packages called mortgage-backed securities (MBS) and sold the debt onto other finance companies (3rd party). In exchange for purchasing MBS & assuming credit risk, third-party investors receive a claim on the mortgage assets and related cash flows, which become collateral in the event of default

6. These mortgages have low interest rate for the introductory period of 1-2 years. Subsequently interest rate will be much higher. However due to series of inflation that hit US economy, Fed Reserve had to increase interest rates to curb further inflation. Now many homeowners begin to face ballooning mortgage payments every month

7. This lead a rise in mortgage defaults & is indicating that the US housing market boom has come to an end

8. The number of defaults caused many medium sized US mortgage companies & banks to go bankrupt. Banks had to write off large losses and this made them reluctant to make any further lending

9. Now in US it has become very difficult to borrow money & raise funds. Cost of interbank lending has also increased. The slowdown in borrowing has a knock on effects towards the US economy at large.

10. Now it seems that the economy is running into a greater slowdown or perhaps even recession given that the price of oil is out of control once again

11. We in Malaysia & the rest of the world is affected as US is the main importer of goods & services around the world. As their economy slows down, their people generally have lower appetite on imported stuffs & hence revenue for many industries from exporting countries will fall. This translates into global economy slowdown

Remember the popular phrase: “When US sneeze, all of us get the cold”

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