Subprime Mortgages: A Catalyst for Global Chaos

One version of chaos theory opines that a butterfly flapping its wings in Beijing could produce a change in atmospheric pressure that in turn could cause a tornado in Kansas. This “butterfly effect” graphically demonstrates the theory whereby a small change in one area can cause a chain of events that leads to a major effect somewhere else. So it was in 2007 when losses in the subprime-mort-funding costs and the widespread belief that if borrowers could not maintain loan repayments, the properties could be repossessed and resold at much higher prices. Credit standards were lowered, and many loans were made to high-risk borrowers, including those in low-income minority areas, who might otherwise have been excluded from the market. It was estimated that US$450 billion, or 30%, of out-gage sector in the US led to downturns in many housing markets around the world, followed by a widespread tightening of credit and turmoil in international financial markets.

Early in the year, there was growing concern about the rise in mortgage defaults in the US housing market and fears of a US recession, which resulted in a global sell-off in equities in February Over the past decade, strong economic growth, moderate inflation, and low ” In the financial sector, Countrywide Financial, the largest mortgage lender in the US, reported a third-quarter loss of US$1.2 billion, its first loss in 25 years.

Standing subprime loans were adjustable-rate mortgages in which the repayment rate had been set for two years before being reset at higher interest rates (plus a margin) in 2007 and 2008. The rapid increase in interest rates by the Federal Reserve (Fed) from 1% in mid-2004 to 5.25% in mid-2006 meant that by midyear 2007 a rising number of the estimated six million subprime borrowers were defaulting on their mortgage payments, and their homes were being repossessed. Combined with an interest rates had encouraged home ownership in the US and other developed countries, while the strong rise in house values made property an attractive investment to more people, including those with poor credit records and low incomes, who could not qualify for prime-rate loans from mainstream lenders. This led to an increase in the competitiveness and proliferation of subprime-mortgage lenders and brokers. Confidence among lenders was boosted by low absence of new buyers (deterred by the higher interest rates), this led to a slump in the housing market. In August sales of new homes were down 21% over the year, and the decline was deepening. As the year progressed, it became increasingly clear that the US problem had global implications and could not be contained. This was because much of the mortgage debt had been rolled into bonds, called mortgage-backed securities, and then rebundled (together with lower-risk assets) by investment bankers in order to gain a higher credit-risk rating. The apparently less-risky bonds were then sold to other investors on the wholesale money market as collateralized debt obligations (CDOs). The market for CDOs was extremely buoyant, and banks, pension funds, hedge funds, and other investors all over the world bought them. Crucially, the complex structure of the market made it difficult to know who was holding the debt and where it was in the world financial system.

By midyear 2007, housing markets in many countries were beginning to falter and house prices to fall. House prices in many other Western industrial countries had risen faster than in the US (up 103%) over the previous decade, led by Ireland (up 253%), the UK (194%), Spain (173%), France (137%), Australia (135%), Sweden (124%), Denmark (115%), and New Zealand (105%). The supply of houses in 2005-06 had accelerated sharply compared with 10 years earlier; again it increased fastest in Ireland (up 210%), Spain (115%), Sweden (113%), and Denmark (76%). In the UK the number of mortgages approved for home buyers fell for the third straight month, and at just over 44,000 in October 2007, it reached a record low. The increased cost of mortgages—combined with the rejection of one in three mortgage applicants— contributed to a decline in the number of buyers for 11 straight months. The rate of repossessions in the UK was accelerating, with nearly 30,000 repossession orders in the third quarter of 2007.

In the UK, Northern Rock had to be bailed out by the Bank of England in September and was the focus of continuing attention. Northern Rock was the UK’s eighth largest bank and fifth biggest mortgage lender, accounting for one in five UK mortgages. The bank had pioneered the securitization of mortgages in the UK, and though other lenders were more restrained, by the beginning of 2007 about half of all outstanding mortgages had been sold off in this way. By late November it was unclear what would happen to Northern Rock, which was being propped up by around £25 billion (nearly US$52 billion) in taxpayer money, with an additional £18 billion (about US$37 billion) in deposits being underwritten by the government.

In June the US investment bank Bear Stearns announced that two of its hedge funds, which invested in subprime-related debt, had registered large losses. In March 2008 the company was acquired by JPMor-gan Chase for a fraction of its value in recent years. The Fed backed the deal with a US$30 billion dollar loan and by lowering its key discount rate of interest. Other funds, located as far away as Australia, also announced losses and froze redemptions. Securities backed by subprime mortgages were also being used as collateral for more borrowing and were putting additional pressure on financial markets. In July there were increasing worries about the exposure of several state-owned German banks to subprime debt, and in early August the French bank BNP Paribas announced that it was suspending funds invested in US subprime-related mortgages because of the difficulty of valuing the underlying assets. Markets were stunned on 9 August when the European Central Bank intervened with an unprecedented offer of unlimited short-term loans to the banking system. It injected €130 billion (about US$179 billion) in order to avert a potential liquidity crisis when overnight interest rates rose to 4.7%, exceeding the 4% cap. The Fed made a more modest intervention of US$24 billion. Further injections of funds continued, and in mid-December central banks gave a record US$530 billion to boost liquidity in credit markets.

Toward the end of the year, sharp declines in the value of the dollar against all major currencies raised concerns of inflation in the US, where the rate of consumer price increases was already accelerating. This limited the Fed’s scope to raise interest rates for fear of the inflationary consequences. In December the Fed detailed plans that, if implemented, would give it more control over the US mortgage market and prevent another subprime crisis. In the UK politicians and financial regulators were planning banking-system reforms to reduce liquidity risk in the future.

Janet H. Clark is an editor, independent analyst, and writer on economic and financial topics.

Next post:

Previous post: