Rising bond yields and Sub prime mortgage crisis in US

Rising bond yields and Sub prime mortgage
                                         crisis in US
    Macro-economic Digest                                                                      4th July2007

An introduction to Sub prime mortgage
A subprime loan is a loan made to someone who could not qualify for a more favorable
rate. Subprime borrowers typically have low credit scores and histories of payment
delinquencies, charge-offs, or bankruptcies. Because subprime borrowers are considered
at higher risk to default, subprime loans typically have less favorable terms than their
traditional counterparts. These terms may include higher interest rates, regular fees, or an
up-front charge. Subprime mortgage loans are riskier loans in that they are made to
borrowers unable to qualify under traditional, more stringent criteria due to a limited or
blemished credit history. Subprime borrowers are generally defined as individuals with
limited income or having FICO1 credit scores below 620 on a scale that ranges from 300
to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage
loans and are priced based on the risk assumed by the lender.

Genesis and history of Sub prime mortgage
It started with fracturing of Banking Regulation in 1982. Vice President George H.W.
Bush headed a task force which pushed through the de regulation. Commercial banks
were permitted to create a category of loans and investments called “off-balance-sheet
liabilities which transformed into the $600-trillion-plus derivatives market. In that year,
under Wall Street guidance, Congress passed the Alternative Mortgage Transaction
Parity Act, which authorized for the first time, thrift institutions (savings banks, and
savings and loan associations) to issue variable or adjustable-rate mortgages (ARMs), and
to make “balloon payment” mortgages. This set the basis for the explosion of the
dangerous “exotic” mortgages of the present, 21st-Century bubble. Fannie pioneered a

1
  FICO is a credit score developed by Fair Isaac & Co scale. It is used by many mortgage lenders that use a
risk-based system to determine the possibility that the borrower may default on financial obligations to the
mortgage lender.

basically new instrument, called a Mortgage-Backed Security, which bundled together
mortgages (from different lending institutions), and sold them to investors. The MBS2,
though they are based upon mortgages, are completely independent instruments, with
their own interest rate and their own increasing level of risk. The volume of MBS, issued
by Fannie Mae, Freddie Mac, and increasingly by Wall Street banks, has risen from a
trickle in the 1980s, to a level of few trillion dollars in the 1990s, to $6.3 trillion today.

The share of subprime loans in total mortgage loans originated in a particular year, soared
from 7% in 2001, to 11% in 2004, to 20% in 2006. However, the volume of loans
outstanding is even starker: this jumped from $140 billion in 2000, to approximately
$350-400 billion in 2003, to $1.2 trillion in 2006. The latter is 12.0% of all mortgages
outstanding. After the “Information Technology” bubble crashed in March 2000, Fed
chairman Greenspan decided to push housing bubble into high gear to replace the IT
bubble Starting in 2001, Greenspan pushed through 13 cuts in Federal Funds rate (the
rate at which banks lend funds overnight); by August 2003, the Federal Funds rate
stood at 1%, its lowest level in 40 years. By design, this pulled down the interest rate on
mortgages.

In 2000, only about15% of subprime loans was undocumented, having no documented
evidence of the income level, place of work, etc. By 2006, some 45-50% of subprime
loan applications were undocumented. One study found that in some more than a third of
the applicants’ income levels were over stated by 50%. Also, a considerable portion of
recent subprime loans were undocumented. By 2006-07, the outstanding volume of
unstable, risky, exotic loans is estimated by sources to be $1.5 trillion. The volume of
subprime loans is estimated to be $1.2 trillion, by the Mortgage Bankers Association.
Separating out the overlap, it is estimated that $2 trillion in mortgage loans are in very
serious condition, with the potential of this spreading through other layers of the whole
$10.2 trillion mortgage sector. As for the banks, they have multiple layers of exposure.

2
 The MBS was created by Lewis Ranieri of Salomon Brothers in 1977, but it required an institution with Fannie Mae’s muscle, to
make the MBS widely accepted and traded.

As of the third quarter of 2006, the U.S. banking system had 11.75 trillion in assets. Of
that amount, 49%—or $5.7 trillion—was invested in real estate, primarily residential
mort gages and MBS, according to the Federal Deposit Insurance The mounting
mortgage defaults and the collapse of the subprime mortgages and derivatives based on
them, has the potential to rupture the banking system.

Current effect of rising bond yields

U.S. financial markets were battered towards the end of first week of June 2007 because
of a dramatic sell-off of Treasury bonds. The yield on 10-year bonds, which has been
rising since May, neared the critical barrier of 5.25% on June 8 -- the highest level in five
years. It made investors anxious about whether interest rates might go up and bring to an
end the period of cheap money that has buoyed up asset markets and also funded a world-
wide boom in mergers. While Wall Street Journal and other major financial publications
feel that inflation is the reason for rising bond yields, Jeremy Siegel, a professor of
finance at Wharton, and author of The Future for Investors has an alternate view of the
rising bond yields. He believes that the real reason for rising bond yields an acceleration
of worldwide economic growth. Interest rates are dependent on two factors: One, the real
interest rate, which is dependent on growth and the other, is inflation. The rise seen over
the last several weeks is a rise in that real interest rate -- not the inflation premium. This
increase in interest rates is a very significant occurrence for all financial markets and
asset markets. Siegel believes that stocks will pause in their upward movement, but
perhaps will fare better than most of the other asset classes. In particular of course, bonds
are going to be directly impacted by higher interest rates. They go down in price right
with higher interest rates. But it will negatively impact real estate in a big way, and
housing recovery is going to be stalled by the increase in rates.

Here comes the part of sub prime mortgage we have been discussing till now. With the
rise in interest rates, sub prime lending becomes more risky and already fragile scene
of sub prime market could deteriorate and it could collapse. If this happens, US
financial markets and hence global markets will be dragged down heavily. Siegel feels

Commercial and industrial real estate will be less affected because the acceleration of
economic growth will bring about more demand for real estate. Still effects will be
negative here. It will be most serious in the owner-occupied residential housing industry,
which is not as strongly affected by swings in the world economy. Clearly mortgage rates
are rising. Fixed interest rates, which had stayed low for so long, are going to get more
expensive -- and that's definitely going to put a pause in the real estate market.

Siegel thinks that the bond market is getting exciting now by going down so much. The
bonds are beginning to look attractive all over the world. Certainly they're not as
attractive as stocks; but the gap between what you can get on bonds today and stocks is
narrow. So the "premium" that you get on stocks, relative to bonds, is going down. He
also thinks that with this tremendous rise in bond yields, we are approaching a fair market
value for stocks, after being undervalued for many years. The risk premiums on bonds
may also be adversely affected which means that the lower-grade bonds may be hit in
some cases more than the higher-grade bonds. That again points towards the collapse
of sup prime mortgage market. Commodities are a difficult one to analyze. The greater
economic activity is a positive boost. But when people hold commodities, they give up
interest rates. And if interest rates are going up, that becomes a more costly hold. They
haven't been negatively affected, but there could be some downward movement in their
prices too.

The dollar has been in a downturn for a couple of years and now with this rise in interest
rates on Treasury bonds, it becomes a little bit more attractive to hold in the U.S. Also all
expectation of a drop in Federal Reserve rates is now gone with the rising yields. This
was a major reason why a lot of foreign exchange traders were selling the dollar, because
they thought that the Fed was going to lower rates to a slowing economy. Siegel feels we
could some more strength in the dollar. The central banks and treasuries around the
world have collected huge funds of cash over the years, because of their support of the
dollar. There's a lot of talk of them diversifying into other assets. The interesting thing
now is that with Treasury bond prices down and interest rates up, there's actually less
of an incentive for them to move into other asset classes than before. They're actually

getting a better return. So the rise in bond yields will not accelerate the movement of
sovereign wealth funds into other asset classes -- it may actually retard that movement.
The rise in the long-term rates is helping the Fed restrain inflation and slow the economy.
So there is less reason now for the Fed to raise the interest rate. On the other side, the fear
of a greatly slowing economy that had dominated the economic headlines a couple
months ago, with the sub-prime mortgage crisis has just faded3. World growth is very
strong and downward movement is unlikely. Inflation is not getting worse, and if the
dollar strengthens a little and we see oil and gold go down, that might also calm fears.
Some people are pointing out that the downtrend of interest rates that they have been
tracking for some 25 or 30 years is now over. It's broken above that downtrend. Siegel
Feels Interest rates should never have been as low as they were back in 2003 [down to
3%], and they are coming back to more normal level. One should understand the fact
that this rise in interest rates is actually coming back to more normal levels; it's high in
relation to what we've had in the last two, three or four years -- it is not high in a long-
term historical perspective.

                                               ***
References

1. U.S. Mortgage crisis can trigger collapse of global casino, Richard Freeman, EIR
Feature;

2. http://www.american.com/archive/2007/march-0307/subprime-time;

3. http://knowledge.wharton.upenn.edu/article.cfm?articleid=1759;

4. http://www.ibtimes.com/articles/20070626/wall-street.htm;

5. Why the US sub-prime mortgage bust will spread to the global finance system, Henry
C.K. Liu, AToL, March 16, 2007;

3
  Next MED would talk about how sub prime mortgage crisis affected LBO and CDO issuances and how
the crises faded away at least temporarily.