Sunday, September 23, 2007

Lend to end!

Sub-prime lending has been the peril of US mortgages

The impending risk that looms over the US is either something that it fails to see or is something that the Americans are ignoring blissfully. The housing boom has although evoked an accelerated growth and employment level in the economy thereby generating alluring wealth effect for whosoever has taken the plunge, it will eventually generate a high default risk and consequent foreclosures. And the villains are those lending companies who have made Americans borrow not just against their present incomes but also against their lifetime incomes. To push the market further they have gone ahead with sub-prime lending - characterised as lending on high interest to people with bad credit history, who do not qualify for the regular loans!

With characteristics that are so jeopardising, to say the least, the steeply increasing rate of foreclosures in the US has led to the shut-down of several sub-prime mortgagers thereby leading to collapse of the stock prices for many in the same industry. Though most of the borrowers resort to adjustable-rate mortgages that give them a low initial rate of interest (around 4%), yet with annual adjustments of about 2% per year these loans end up filching around 10%. Between 2004-2006, around 21% of all mortgages were sub-prime, a sharp rise of 9% from that of the previous eight years. In 2006, the cumulative amount of sub-prime lending reached a staggering $600 billion, 20% of which was contributed by the US home loan market alone. The Mortgage Bankers Association has estimated an aggregate housing loans (sub-prime) default of around 5% of the total in the last quarter of 2006 and a default of 14.5% on high risk sub-prime loans. In April, this year, Lehman Brothers speculated the mortgage defaults to be anywhere between $225 billion and $300 billion. The most transparent cause for the failure of sub-prime lending is the prevalence of ‘Liar Loans’ where the borrowers conceal their actual income and as has been seen in more than 60% of the cases, the borrowers have inflated their earnings by more than half. Another obvious reason behind the messy sub-prime lending is that the Americans who choose to participate in sub-prime lending are minorities, women and lower income borrowers who cannot afford to indulge in their fancies but are only enticed by the unabated consumerism fuelled by the sub-prime lenders.

I wonder where the lenders go from here. As the US has those many Americans and almost all of them, irrespective of their credibility, is neck-deep in debt already, so to sustain their businesses these lenders would have to scout for other markets. And for obvious reasons their next target would be economies like India and China, where favourable demographics and huge population makes them an attractive destination. No doubt the policy maker’s role in the respective economies (India and China) would be critical here as just like the US economy, in no time these lenders can push India and China into a crisis. And to an extent the two economies are more vulnerable than the US economy as the purchasing power is much lower as compared to the Americans.


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