Are Mortgage Debt Problems Just Beginning?

Over the past few months, a lot has been written about the problems being experienced by sub prime mortgages in the United States.  What has not been written about is the fact that the institutional debt trading market has virtually dried up.  That is a real issue, given that many corporates, including some of the world’s major banks, have to restructure their capital base because of the introduction of new financial reporting standards.  An example of this is the major French Bank, Credit Agricole.  They are currently fund raising in New Zealand, as Kiwis still have an appetite for investing in debt.  The initial response to this offering was somewhat lukewarm.  They have subsequently raised the margin above the five year swap rate, so it will probably have a fixed interest rate for five years of around 9.85%.  This is about 2.2% higher than what New Zealand trading banks are offering for a five year term.

This month will see the first of the two year “mortgage war” mortgages having to be refinanced.  Two years ago, the interest rates were around 6.5%.  These fixed term borrowers will need to refinance.  If they go for another two years, they will most likely see the interest rate increase to at least 9.20%.  For those with a $250,000 mortgage the increase in interest payments per week will be around $130.  A number of borrowers may well find that this is unsustainable.  They may have some comfort in that according to their recently received QV notices, their properties have most likely increased in value.  Their equity position has therefore improved.   The reality may be that as the number of distressed sellers increases, property prices could weaken.

So let’s go back and see what went wrong with the sub prime mortgages.  Dozens of major banks in the USA, Britain, Europe and Asia have lost tens of billions of dollars through buying CDO’s based on sub-prime mortgages.  So how did it happen? It began with over-confident and greedy investments by banks (and investors) in the US housing market.  House prices kept rising; some thought they would never fall.  Mortgage brokers and banks, working together chasing easy profits, set out to help property developers sell more houses to mostly new or poor Americans who historically had been unable to afford a house.  They offered loans effectively to anyone at all without proof of income.  So the borrower, often without any real job, filled in the loan application which was forwarded to a bank that would accept a "no doc" loan.

The Banks offloaded their risk by going off to Wall Street.  The finance whiz kids arranged for the loans to be given credit ratings based on historical default rate data.  The loans were broken into three parts, each with differing levels of risk and sold off.  Fund managers, banks and pension funds bought up the parts they liked and the banks, which originated the loans, had their money back and their fees.  Some of the institutions geared their investments.  That was fine, until mortgage defaults increased with rising interest rates.  And by the way, several New Zealand fund managers have direct exposure to these problem CDO’s.

Next year more than a hundred billion dollars of such loans will have their interest rates reviewed.  The chances are they will be seriously increased as the supply of new funding has virtually dried up.  The "owners" of these homes, unable to pay, will walk out further depressing an already distressed USA housing market.

If you think that this is just a USA problem, you are mistaken.  We are in a global market and our banks borrow offshore to provide mortgage funding particularly for fixed term mortgages.  Banks will have to pay more for the credit, which means those with mortgages that need renewing will invariably have to pay substantially higher interest rates than they are paying now.  And also remember that interest rate margins are increasing to cover expected default increases.  It is quite a vicious circle, and unfortunately the economy as a whole is likely to suffer.