Money
Issue No. 39 - February/March 2008
American nightmare: what‘s to come
by Darryl Gobbett
Sub-prime essentially refers to the home loans made in the USA to borrowers with less than prime credit standing. Many of these loans are now in default.
But why have these credit failures almost bought the international financial system to its knees and the US to the brink of recession?
The genesis of the current problems has to be seen in the very low interest rates in the US from 2001 and the high levels of securitisation of home loans in that country’s finance industry.
In the aftermath of the technology meltdown on US sharemarkets and the terrorist attacks on the USA, the US Federal Reserve cut interest rates to the lowest levels since the early 1950s.
The drop in interest rates and the high level of liquidity in the US financial system as the Federal Reserve sought to stave off recession, along with a fall in business borrowing demand, sharply increased the capacity of home lenders to make new loans.
One response was a reduction in prudent lending standards.
To quote Dr Ben Bernanke, Chairman of the US Federal Reserve Board, in a speech given on 10 January 2008:
“Although poor underwriting and, in some cases, fraud and abusive practices contributed to the high rates of delinquency that we are now seeing in the sub-prime ARM market, the more fundamental reason for the sharp deterioration in credit quality was the flawed premise on which much sub-prime ARM lending was based: that house prices would continue to rise rapidly.”
Part of the response was increased marketing of ARMs (adjustable rate mortgages) or what we call variable rate home loans, often with low, ‘teaser’ initial interest rates or interest-free periods.
This was in contrast to the more usual US practice of 25 to 30-year fixed interest rates for prime home loan borrowers.
Again, these types of variable rate loans targeted borrowers who may not have been able to meet the repayment requirements of the more expensive ...
