What Caused The Sub-Prime Crisis?
A look at the history of the sub prime crisis, and how to plan today for the uncertainties of tomorrow.
A sub prime lender is an institution that offers loans to borrowers with a poor credit history who do not qualify for standard, lower-interest loans. The practice of sub-prime lending is controversial. Since sub-prime loans (also known as B-paper loans) involve higher interest rates and riskier borrowers than normal (A-paper) loans, the practice has come under criticism from experts and consumers. Many sub-prime lenders have been accused of predatory lending practices such as lending to individuals who have little chance of being able to meet their debt responsibilities. This often then leads to default, seizure of collateral and foreclosure.
Regardless, sub-prime lending has accounted for approximately 20% of all home loans in the United States since 2004. Sub-prime loans work fine - when property prices are on the rise and interest rates are low. But when the real estate bubble burst in the U.S., the sub-prime market entered what many are calling a meltdown in late 2006, and is yet to recover.
The decline in property values saw many home owners unable to meet their financial commitments, and lenders were left with no means to recoup their losses. Foreclosures and bankruptcy followed, and the crisis began to snowball. In 2007 things got even worse, with a surge of foreclosures twice as bad as in 2006. Home sales and prices continued to fall in the U.S. and interest rates were still rising. The situation began to put pressure on the near-prime and prime mortgage markets. Investors have lost billions of dollars in investments that were tied to sub-prime mortgage assets. This in turn triggered disturbances in the global markets, including Australia.
A report by The Economist Intelligence Unit commented "Asset bubbles almost always end in tears, and the US housing market is no exception" The report continued, "Banks and investors are now being punished for ignoring risk, lending recklessly and thinking property prices would always rise."
In a worst-case scenario, the housing market slump in the U.S. could cause interest rates to rise further in Australia, stretching home owners to their limits. Aussie interest charges are already among the highest in the world, according to the report.
Fortunately for us, the crisis is yet to affect Australia to anywhere near the same extent as it has in the U.S. Only a small portion of all loans here are of the sub prime variety, so a local meltdown is far less likely to occur. Our share market has remained relatively strong despite declining U.S. stocks, and our economy has remained steady. Property values are still on the rise, despite interest rate hikes, and more importantly, demand for property is increasing. With election time looming towards the end of 2007, some may be tempted to hold off on any major financial commitments. However, no matter who wins the election we can expect interest rates to remain relatively stable in the current economic climate.