Does the subprime collapse affect your mortgage?

Andrew Griffin - CEO
September 2007

Over the past few weeks a number of our clients have been asking questions about the possible flow-on effect on their commercial borrowings resulting from the Subprime residential mortgage collapse in the US: What does it actually mean and will it effect lending margins in Australia in the short, medium or long term. First a little background.

Subprime loans were created by residential lenders in the US seeking volumes for their lending programs. The 'prime' residential market was highly competitive and lending margins had been compressing for years. Assisted by Wall Street financial structuring, residential lenders in the US developed products that fell outside of the normal prime residential market. This was typified by making loans available to ever-more 'credit challenged' borrowers. These loans were euphemistically known as NINJA loans after the status of the borrowers (No Income, No Job or Assets). These 'sub-prime' loans not only generated massive volumes at healthy margins for the lenders but they also created a whole new class of borrowers that historically had been unable to borrow.

One of the key elements of Subprime loans is that borrowers were granted a protracted 'interest honeymoon' period which meant they either paid lower or no interest in the first and often second year of a loan. It was therefore difficult for a Subprime borrower to default on the loan during the first two years. This had two disastrous effects. Firstly the default rates for Subprime loans were, initially, almost non-existent. This empowered the Subprime lenders to borrow even more aggressively from their own funders and grow their portfolios exponentially. The numbers of new Subprime loans advanced are as follows:

US$110 billion in 2000
US$175 billion in 2001
US$300 billion in 2002
US$474 billion in 2003
US$647 billion in 2004
US$805 billion in 2005
US$722 billion in 2006.

Secondly it created 'time-bombs' in these portfolios. It was merely a matter of time for the honeymoon periods to expire and the defaults to start occurring in great number.

So who was lending these Subprime lenders the money? The source was the investors in the global debt markets who were being 'fed' heavily structured lending models that, in hindsight, managed to hide the intrinsic riskiness of Subprime loans from the investors.

In simple terms lenders would raise senior, mezzanine and equity tranches from wholesale warehouse lenders to fund the initial Subprime mortgage portfolio. The mezzanine and equity pieces of this mortgage portfolio were then bundled together with the mezzanine and equity tranches of other mortgage portfolios to create a securities portfolio or Collateralised Debt Obligation ('CDO'). The CDO was then 'magically' re-rated by the ratings agencies to create further senior, mezzanine and equity tranches. These were also sold in the debt markets to margin-hungry investors. The CDO senior tranche, however, has a risk profile considerably greater than the 'mortgage portfolio' senior tranche. It appears that this 'slipped through to the keeper'.

The CDOs therefore represented the very riskiest piece of all of these Subprime loans in various mortgage portfolios. So when the underlying Subprime borrowers started to default on their mortgages, entire CDOs were wiped out.

So how far-reaching is the problem? Subprime mortgages are estimated to be approximately US1.5 trillion of the US$12.0 trillion dollar mortgage market. The CDO market is itself (which bundles all sorts of securities not just mortgages) is in excess of US$2.5 trillion of which a not insignificant proportion relates to the Subprime mortgage market. The ramifications for the CDO market itself are disastrous across all asset classes. The contagion has already spread into the prime markets (both mortgage and corporate) and we should not forget the knock-on effect to the American housing market from mortgagee sales.

The short term ramifications of the Subprime collapse are hard to predict accurately. There is, however, one very clear lesson that will be learned. Money has a price and riskier money has a higher price. This simple nexus was lost in the Subprime/CDO debacle. Risky investments were priced too cheap by margin-acquisitive investors and in the wake of the Subprime driven credit collapse credit spreads have soared as credit risk is re-priced and the capital markets de-gear.

In Australia local securitized lenders and CDO investors have already been effected. Numerous residential lending programs have pulled bond issues due to the absence of liquidity in the non-prime markets and the 'flight to quality' in the prime markets. There are economic imperatives at play (institutions both invest and fund from the debt markets) which will effect corporate returns and pricing for the foreseeable future in this sector. Re-pricing upwards of credit-risk across all sectors will occur and many finance company style lenders will come under pressure to fund their mortgage portfolios.

Balmain has been lending and originating commercial mortgages for nearly 30 years and has witnessed a number of credit cycles at the coal-face. In our opinion there is little doubt that 'correct-weight' will return to credit-pricing and margins will start to 'thicken' across corporate and mortgage debt. So what will our lenders, mainly mortgage funds and banks, do to your mortgages as credit spreads (margins) widen?

The major trading banks fund their loans from a mixture of capital, non-interest bearing credit accounts (your and my cheque accounts) and on market borrowings. Increased allocations of capital and increases in the cost of wholesale funding will drive up the bank's cost of funds in the mortgage sector and there will be a consequential passing on of unabsorbed 'margin' to borrowers. On the other hand mortgage funds, except those that invested in sub-prime mortgage backed securities, have no direct disaffection from movements in debt market spreads. Similarly whilst the banks may chose to prefer other fixed interest asset classes over mortgages, the Mortgage Funds remain dedicated to lending to the mortgage market. It is unlikely that we will see the same illiquidity in the 'bank' commercial mortgage market as occurred in the early 90's however we do expect that the banks will stop leading the charge of margin compression that has dominated this decade

We are also concerned that the banking system will seek to pass on increased costs directly to the borrowers in respect of existing loans. Bank documentation generally allows the bank to vary their margins due to significant market corrections and while we have seen limited evidence of this re-pricing to date it is early days and we remember well the propensity of the banking system to change terms and conditions during the last major shakeout in the early 90's. Balmain's consistent offering to our clients for 30 years has been to assist you to protect your position in an ever-changing debt market. Our comprehensive industry knowledge can be a guiding light for your debt portfolio.

The good news is that underlying commercial property fundamentals remain strong in Australia and corporate performance outlook remains positive with the fundamentals strong we doubt that we will witness a calamity for borrowers in the commercial mortgage market as occurred in the early 90's. We do, however, caution borrowers that the sub-prime crisis may signal the end of the never ending reduction in loan margins that has been the hallmark of the last 5 years. The honeymoon is over... at least in the short term.

Balmain remains committed to helping our clients, both old and new, to identify the optimal source of funds for their mortgages, be it for investment or construction.

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balmain + commercial + publications + september 2007

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