The US sub-prime crisis in graphics

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.

THE NEW MODEL OF MORTGAGE LENDING

How it went wrong

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.

THE RISE OF THE MORTGAGE BOND MARKET

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.

HOW SUB-PRIME LENDING AFFECTED ONE CITY

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THE SUB-PRIME CRISIS IN CLEVELAND

	Sub-prime lending		Black areas
	Foreclosures (repossessions)		Deutsche Bank properties

<br /><img id=”myImage” src=”/nol/shared/spl/hi/uk/07/subprime_crisis_dc/img/foreclosures_2_416×376.gif” /><br /> <img id=”myImage” src=”/nol/shared/spl/hi/uk/07/subprime_crisis_dc/img/black_regions_416.gif” /><br /> <img id=”myImage” src=”/nol/shared/spl/hi/uk/07/subprime_crisis_dc/img/deutsche_bank_2_416×376.gif” />

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.

THE CRISIS GOES NATIONWIDE

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 “balloon” mortgages.

The payments were fixed for two years, and then became variable and much higher.

Consequently, a wave of repossessions is likely to sweep 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 HOUSING PRICE CRASH

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.

HOUSING AND THE ECONOMY

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.

CREDIT CRUNCH

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.

BANK LOSSES

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.

BOND MARKET COLLAPSE

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.

12 Things The Holidays Teach Us About Investing

There’s the “12 Days of Christmas” and there’s also my twisted version, the one I refer to as the “12 Things The Holidays Teaches Us About Investing.” Check it out:

The holidays: While I’m all for the big holiday parties and lavish events, looking back at our most memorable holiday moments, I bet many would agree it’s the simple moments spent with family and friends that are typically the most rewarding.

Investment lesson learned: Learn from the holidays. Simple investments such as the S&P 500 (that typically outperforms most professional money managers) teach us that it doesn’t have to be complicated for it to be effective.

The holidays: Turn on a holiday newscast and there’s a decent chance you’ll see a story about a handful of frenzied shoppers searching all over creation to find that one last Wii. … Who scored them? That’s simple: the persistent ones who refused to give up.

Investment lesson learned: Just like the holiday shoppers who scored this year’s Elmo, it’s those who don’t give up that often find the treasure. Whether it’s a great opportunity or a creative investment with returns that would make even The Donald proud, finding the good stuff takes time, education and, of course, a willingness to never give up.

The holidays: Did you hear about the holiday shoppers going to Target at 4am? Maybe you were one of them. Understanding the value of bargains, many holiday shoppers take their time to start early, compare costs and find the deals. Doing so accomplishes one key thing: give them a better bang for their buck.

Investment lesson learned: Who thought Warren Buffet and my Aunt Harriet would be so much alike? When it comes to finding undervalued stocks, sifting through the market bins of Wall Street for discounts gives you the best chance to maximize upside while trying to reduce investment risk.

The holidays: When it comes to opening holiday gifts, there’s little worse than seeing a kid who regretfully discovers “not all pieces shown are included.”

Investment lesson learned: Learn from Little Billy gone wild. Whether it’s the presents you give or the money you invest, avoiding the surprises is a job well done. Before investing, read the fine print; that stuff is always more important than the window dressing itself.

The holidays: What holiday would be complete without Auld Lang Syne, It’s A Wonderful Life, Times Square and a hangover to boot? There’s a reason those things and more have lasted the test of time: because they do a timeless job of bringing the true meaning of the holidays into our hearts and homes.

Investment lesson learned: Whether it’s Ben Graham’s legendary “Intelligent Investor” or many other timeless principles of prudent investing, the holidays teach us that if it isn’t broken, why try and fix it?

The holidays: High School, New Year’s Eve, 1982. With my mane of hair, A Flock Of Seagulls, Jordache jeans and one beer too many, falling over Crazy Julie and landing in the hospital to get a head of stitches proved that yes, too much of one thing really can hurt you.

Investment lesson learned: The history of investing is ripe with examples of over-indulgence. Whether it was tulips, dot-coms or the current real estate mess, the holidays teach us that while too much of one thing may not give you a head of stitches, it can easily render you broke.

The holidays: While toaster ovens, dishes and socks have their place under the tree, it’s the creative gifts — the thinking out of the box — that is often remembered the most.

Investment lesson learned: Market gone bad? Selling your stock? Remember: every time you sell, there’s someone on the other side to buy. … who’s doing such a thing? Aliens from another planet? … Not quite. Those buying your stocks obviously think differently, take educated chances, get creative and could wind up reaping some great buys.

The holidays: Want to ruin your girlfriend’s gift? Have me wrap it. … To avoid such despair, here’s a better suggestion: take it over to the mall wrapping station. With precision creases, perfect bows and curly color laces, giving your girlfriend a gift with their touch makes a big difference in showing her you really do care.

Investment lesson learned: Want to ruin your investments? Don’t pay attention to fees and taxes. Neglecting those important details will accomplish one key thing: lower your returns. So, the next time you invest, take a moment to think of those nice people over at the mall. Doing so should remind you that whether it’s gift-wrap or your investments, it’s the details that count.

The holidays: Leaving town for the holiday? Whether it was pricing tickets, figuring out a route or making hotel reservations, what trip would be a success without taking the time to plan it?

Investment lesson learned: Looking forward to retirement? In markets like these, I certainly am. And just like planning a trip, not having a financial destination often leads to nothing but regret. After all, this is your life we’re talking about, remember?

The holidays: While a front row ticket to Springsteen, a Pug or a Costco-sized case of Famous Amos are all gifts I couldn’t turn down, the holidays teach us it’s the gifts we give – not the ones we receive — that bring us the most reward.

Investment lesson learned: While charitable donations and tax deductions might be all well and good, it’s a daily act of random kindness that personally turns me on the most. Want to make someone’s holiday? Try my personal favorite: pick a random table at a restaurant and pay for their meal. …Want to really blow them away? … Don’t let them know it was you who did it.

The holidays: The experts on resolutions, whoever and wherever these people may be, tell us the more resolutions you make, the less likely you are to keep them. To make them work, keep them short, simple and attainable. Otherwise, they’ll rarely be kept.

Investment lesson learned: Listen to those nutty resolution experts. Pick one or two investment ideas for the New Year, and if you can’t think of one, try this: save $100 dollars per month and invest it into a low cost, tax efficient and highly productive stock index. At a 7% hypothetical annual rate of return, in 10 years you’ll have roughly $17,000. … How good is that?

The holidays: I don’t know about you, but eleven months, three weeks, six days and a few hours into this year, I need to finally get some rest. With that, the holidays are a perfect time to take a moment to kick back, watch the Jets lose another one, eat lots of unhealthy stuff or do whatever it takes to make you happy.

Investment lesson learned: Recession? Higher oil prices? Inflation? More sub-prime mess? For one fleeting, quick and luxurious moment, take a profound breath to say, “who cares?” … After all, there’s nothing wrong with taking a moment to live this wonderful thing some call “life.”

I want to wish you and your family a very happy and successful New Year.
See you next year…