US sub-prime mortgage crisis

inSight

10 Jan 2008

US sub-prime mortgage crisis

The US authorities and credit providers will have some tough decisions to make in order to contain the crisis.

Last week I had a glimpse of a television interview with a sub-prime mortgagor in the United States. She was in tears over how hard it has been to service her mortgage, which she has not managed to do for four months. She obviously had problems in making ends meet and was finding it almost impossible to realise her dream of owning a home.

It was difficult not to sympathise with her plight. She probably took out the sub-prime mortgage two years ago in the hope that property prices would continue to rise, so that she could, if worse came to worst, service her mortgage by taking out a second mortgage on the increased value and perhaps even have a little to spare to spend on that nice carpet on display in the mall. But now, with the low, so-called teaser rate having been re-set to a much higher level, her mortgage payments have gone up substantially. And as property prices have gone down instead of up, even though many people said this would not happen in the United States, there is no way she could get a second mortgage to help out, let alone buy that carpet. She is probably about to join the rapidly lengthening list of sub-prime mortgagors in default, as the delinquency rate of sub-prime mortgages rises to the high teens, and that probably means losing her home. All her mortgage payments in the past two years since purchasing the home have gone down the drain and she is probably in negative equity, something some of us in Hong Kong are all too familiar with. Fortunately, the practice in the United States is that she is unlikely to be taken to court for her personal liability over the shortfall when her "home" is re-possessed and re-sold in the market. But then there is all this talk about the credit crunch slowing the economy and the 50-50 probability of the economy even going into recession, whatever that means. For her, however, this means a higher probability of being laid off, or having to take a cut in take-home pay. Life really is tough.

Some would say she should not have been given the mortgage, or rather misled into taking out a mortgage, in the first place. Prices go up and down and the property market is no exception, as we all know so well in Hong Kong. It is true that the combination of the abundance of land, free and nearly perfect competition, and the much shorter time lag with which supply adjusts to demand (it takes much less time to build a stand-alone house than a high-rise block of flats) means the dynamics of the housing market in the United States are a lot different from Hong Kong. But the law of gravity for prices in free markets still applies. I certainly hope, and am confident, that the kind of adjustment we saw a few years ago in Hong Kong, involving a fall of 65% over five years, will not take place in the United States. But it is all a matter of degree. And the ability of households to cope with significant adjustments in housing prices also differs in different jurisdictions, depending on factors such as the savings rate (and therefore the staying power of savers), the labour-force participation rates of household members and the social-security systems. Overall, however, it does appear that the average household in the United States, and therefore the United States economy, is rather more vulnerable to significant downward adjustments in housing prices than would be the case in, for example, Hong Kong.

In terms of containing the damage to sustainable growth, there has been talk by the US authorities and credit providers of holding down and perhaps reversing the upward trend of the delinquency rates of not just the sub-prime mortgages but also the prime ones (in a declining market, a prime mortgage can easily fall into the sub-prime category) by providing some assistance to the mortgagors. Of course, moral hazard is a concern and I understand there is quite strong political objection to the use of public funds to bail out borrowers who have over-extended themselves and lenders who have not been diligent enough in adhering to credit standards. But in a situation like the one we are seeing, there may be a threshold beyond which moral hazard becomes less of a concern. For the lenders, or rather the "unfortunate" lenders, who have had to re-absorb sub-prime-related financial instruments onto their books, I suppose it is a matter of dollars and cents. But unfortunately it is also a matter of who are prepared to bite the bullet and put the matter behind them. It is not an easy decision. But my experience with the monetary and financial systems of Hong Kong for a quarter of a century tells me that operators in the financial system, in whatever capacity, cannot afford to do too little too late.

Joseph Yam
10 January 2008

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