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Housing Market of Cards

Prepared by: Lee Hudson Teslik
March 28, 2007

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Subprime loans are, by definition, risky business. They target home buyers with poor credit records or without cash for a down-payment, often luring in borrowers with lowball introductory interest rates that morph into more robust charges years down the road. If a lender can properly assess default risk—and tolerate quite a lot of it—subprime loans can turn a neat profit. They also provide entrée into homeownership to consumers once frozen out of the market. This win-win situation works so long as each side knows what it’s getting into. But where lenders or borrowers—or both—get carried away, trouble looms. For evidence, look no further than the United States, where an overeager subprime market (TIME) rapidly devolved into a fiasco.

Across America, risky mortgages are going up in smoke. U.S. mortgage foreclosure filings sky-rocketed (Bloomberg) 12 percent last month, and at least thirty subprime lending firms failed this year. New Century Financial, formerly the second-largest subprime outfit in the United States, is the most glaring cautionary tale (MarketWatch)—the company is now auctioning assets in what many analysts view as a precursor to imminent bankruptcy. For global lenders, many of which are less active than their U.S. counterparts in subprime lending, the fate of New Century and other struggling American firms is a cautionary tale.

No single factor caused the subprime meltdown. Borrowers, of course, should theoretically shun loans they cannot possibly repay. In one notorious case highlighted in the Economist, a twenty-four-year-old in Sacramento bought seven houses in five months, never paying so much as a down payment—and now faces $2.2 million in debt. Lenders also shoulder blame for cavalierly offering loans to unqualified borrowers. In good times, unsustainable loans still turned a profit (MSNBC); the lenders reaped short-term fees and quickly sold the loans to investment banks which chopped them up, repackaged them, and flipped the debt to hedge funds and institutional investors. Now the gravy-train is derailing, and as CFR’s Sebastian Mallaby argues in the Washington Post the investment banks could be exposed as the real scoundrels of the subprime blowup. The banking giants “bamboozled ratings agencies into assigning misleadingly high credit scores to some mortgage-backed bonds,” Mallaby says. This enabled them to pawn off bad debt, disguised as good debt, to unwitting investors.

How far will the damage extend? Bloomberg, in the article cited above, says subprime housing-loan woes could spill over into the auto-loan industry, where highly speculative loans are also prevalent. The issue has global ramifications as well: In late February, subprime concerns sent stock markets tumbling on fears of a U.S. economic slowdown. Even though subprime loans aren’t nearly as common internationally as they are in America, a U.S. credit crunch could still suck liquidity out of global financial markets. Testifying before Congress on March 28, the U.S. Federal Reserve Chairman Ben Bernanke said the subprime issue thus far has had only minimal effects (Reuters) on the broader U.S. economy. But some factors remain unknown. Perhaps the most frightening question is what happened to all that bad debt the investment banks pawned off. Hedge funds, the Financial Times’ Gillian Tett points out, are often masters at using tricky paperwork to cover up their losses. But somewhere, somebody is taking a heavy hit right now. Tett wonders: “Where are the bodies buried?”

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