What is Sub-Prime?
Sub-prime refers to the weakest credit quality segment of the US mortgage market, which consists of three segments: Prime; Alternative A (Alt-A) and Sub-Prime. The sub-prime segment is made up of loans made to debtors with impaired credit histories.

Heavy competition in the US mortgage market over recent years stoked by a run-up in residential property prices and cheap interest rates fostered increased aggressiveness from mortgage businesses. Loosened credit standards fed the sub-prime wave; willing buyers of this debt provided the necessary demand for this segment.

Why the sudden interest in US Sub-Prime?
The first signs of trouble emerged in February 2007 when New Century (large originator) filed for bankruptcy and HSBC announced it was setting aside more than 20% more in reserves than expected to cater for the weakening US mortgages market. This occurred at around the same time the Chinese stock market wobbled although little attention was paid. However, the now common daily discourses largely began when two US domiciled Bear Stearns hedge funds with leveraged exposure to the US Sub-prime market imploded in June 2007.

Problems quickly surfaced afterwards in Australia with Basis Capital and Absolute Capital suspending transactions last July and Macquarie’s Fortress suffering a severe decline in value. More recently in August, funds in Germany (WestLB) and France (BNP Paribas) with sub-prime exposure have also been suspended. At the time of writing, Basis Capital released a note advising that up to 80% of the value of its Yield Fund may have been lost.

In aggregate sub-prime mortgages make up approximately 15% of the US mortgage market; however this segment has experienced rapid growth since 2003 and 20% of all mortgages in 2006 were sub-prime. A confluence of rising interest rates, overstretched household budgets and slumping housing prices have conspired to create the ‘perfect storm’ which is shaking-out the sector. Of course, it hasn’t helped that borrowers of dubious quality were extended credit. Individuals that would not have normally qualified for loans were assisted with rising property values and fancy new loan structures with exotic terms. Terms such as teaser rates: discount rate in first two years followed by steep increases to make up the initial honeymoon period.

Sub-prime loans of the 2005 vintage which started resetting this year (i.e: the interest rate went up) have contributed to the rising defaults and seemed to have precipitated the decline in confidence. Also, there was an increase in floating rate loans which became more expensive with rising interest rates. It is important to note here that the US mortgage market materially differs from Australia’s with respect to fixed versus floating interest rates. The bulk of the US market is constituted of long-term fixed rate loans directly opposite to Australia’s bulk floaters. While in the past, debtors relied on the ability to refinance their way out of trouble they are now finding it more difficult. Lenders have tightened their standards responding to regulatory and market pressure. Basically, this means that unofficially distressed debtors cannot refinance on more attractive terms and are stuck with mortgages they cannot afford – hence the distress.

The prognosis for sub-prime appears to be bleak, and likely to continue to be bumpy, particularly as the 2006 vintage begins to mature into 2008. The surfacing troubles have led credit ratings agencies to reconsider their earlier views and downgrade assessments on this debt and instruments created with these assets (e.g. CDOs) – adding fuel to the fire. The rise of complex debt instruments which packaged up such assets and ultimately managed to convert them to AAA status through “financial alchemy” arguably fed the demand for these mortgages.

Can Australia experience a Sub-Prime event?
The Reserve Bank of Australia (RBA) has previously noted that Australia does not have a sub-prime market. The closest low quality paper available is the non-conforming market (e.g. lo-doc loans) making up roughly 1% of outstanding mortgages. The counterpart in the US is the Alt-A market. At present there is no indication that Australia’s credit conditions are worsening. The rising yields and widening credit spreads appear to be more a function of fear rather than deteriorating domestic fundamentals.

If the Sub-prime sector is small, what’s with all the commotion?
There has always been consistent chatter that risk was not being appropriately priced. The distress has provided a rude awakening and forced the markets to reassess risk and how it is priced. Despite the US Sub-prime market representing a relatively small sub-set of the fixed income universe, investors and market participants have become jittery. Jittery markets mean increased volatility and reticence in make new investments (supplying liquidity). The re-pricing of risk can be seen from the wholesale widening of credit spreads (good for new investors, bad for existing ones) across all credit quality. For the time being, at least, the rose coloured glasses have been are out of style.

Accompanying the spread issues has been the talk of increased circumspection from lenders. This is casting doubt on whether the past ease and accessibility to credit will continue and impacting (increasing) the cost of debt. This has repercussions for corporate borrowers and equity markets. The increasing cost of debt pushes up the cost of equity which in turn impacts valuations; the greater cost of equity (required return), the lower the valuation. Recent examples include the seizing up of the high yield market in the US, with private equity firms finding it difficult to source the cheap debt of the recent past to fund their leveraged buy-outs, e.g. KKR threatening legal action to force through their deals. Slowing private equity activity has potentially negative implications for the Merger & Acquisition boom which has propelled most major world equity markets.

Australian markets are not immune. Members Equity was forced to pull a mortgage securitisation issue following the evaporation of demand at ‘old’ pricing. Very recently central banks including the Fed, ECB and RBA intervened in debt markets by providing liquidity to keep benchmark interest rates at their targeted levels.

What to expect going forward?
Continued uncertainty in both debt and equity markets should be expected. It is unlikely that the Sub-prime woes have worked themselves out of the system. As previously mentioned, there is still the 2006 vintage to mature. The danger is the spreading of fear and panic – contagion risk. The news on the economic front across the globe still remains broadly positive, so in theory continued support for asset values remains in place. However, this sort of information matters little when investors and markets become ‘spooked’.
Indiscriminate sell-offs and portfolio risk reduction could decimate asset values and lead to a self-fulfilling prophecy. Assets that are more sensitive to bad news like high yield debt assets are at most risk.

It is difficult to foresee a large fall in home prices but if property prices continue to go up at the rate of recent times, only a small percentage of people will be able to afford a house.

The ABC Four Corners program ran a story on the 17th September 2007 called “Mortgage Meltdown” and is worth viewing.