RCR Finance Bulletin # 1 - Friday, September 7th, 2007
US Sub-Prime Update I've received numerous calls from concerned clients asking about the US sub prime market and the effects this may have on our loans here in Australia. As I result I thought it might be appropriate to clarify the position to you all. Unfortunately this bulletin is a little lengthy, but please take the time to look over it. US sub prime market – What is it and why does it matter? The “US Sub Prime Market” is the sector of the US residential mortgage market that caters to low income and bad credit history borrowers. In 2005, the United States real estate market experienced a boom, and as part of this, lenders became more creative to make home ownership more accessible to the wider population, particularly those who normally wouldn't have been able to afford to do so. Creative lending practices included: Therefore, as the interest rates increased on these types of loans, many sub prime borrowers could not meet their repayments and subsequently defaulted on their loans. It is now believed that up to 7 million people in the US have taken out sub prime mortgages. Why has the fallout from the US sub prime market affected Australia? The crisis spread because many sub prime mortgages in the US have been “packaged” by lenders with the help of investment banks and sold around the world to financial institutions and hedge fund managers. These packages are often referred to as ‘Collateralised Debt Obligations’ (“CDOs”). In basic terms, as the value in the US real estate market began to decrease and the level of defaults began to increase, the investments in these CDOs became unviable to the point where many major investors lost substantial amounts of money. Some Australian fund managers have been affected. There has been some concern that the Australian mortgage market may follow suit however, in Australia there are significant differences, so that it is considered unlikely that the negative impact will flow into Australia to the same degree. We need to remain aware however, that as some Australian lenders do source their funds from US and other affected sources, that these lenders have and will be affected to some degree, with the flow on effect to ultimately be passed on to borrowers. The most recent lender to announce a "US sub-prime flow on effect" rate rise is Adelaide Bank. What is the Australian lending markets position and what are the differences? It has been our experience that because of Australian lending institutions more robust approach to lending, the problems experienced in the US sub prime market should not affect as badly for the following reasons: IN SUMMARY Some borrowers may be affected by the US fallout if their lenders source some are all of their funding lines from overseas markets, with the less affected being those with lenders that source funds locally. DISCLAIMER...The information contained within this Newsletter / Bulletin is of a general nature only and is not intended to be relied upon or to be construed as the giving of professional financial, legal or economic advice. RCR Finance Pty Ltd makes no warranties or representations whatsoever regarding the quality, accuracy, or otherwise of any material contained within this Newsletter / Bulletin. RCR Finance Pty Ltd will not be held liable to readers or users of the material contained within this Newsletter / Bulletin for any loss or damage however caused resulting from the use of the material. All readers or users are advised to seek their own independent professional financial, legal or economic advice.
Many Australian lenders loans have neither been packaged in the way the US loans have been nor have they been funded by the US capital markets, so these lenders are not directly exposed to this specific risk in the broader financial markets. In the US, most mortgages are issued on a fixed 15 or 30 year mortgage basis, while the underlying funding is from short term capital markets debt paper.
Most Australian mainstream lenders do not lend to sub-prime borrowers, this market is serviced by specialist lenders with specific expertise in this field. All lenders assesses the capacity of borrowers to service their loan commitments by obtaining (depending on the circumstances) a combination of:-
Generally, Australian lenders lend to a maximum of 80% of a property's valuation, but some can lend up to 100% of a property's value with the assistance of Mortgage Insurance (i.e. the Mortgage Insurer covers the lenders risk of lending up to the extra 20% portion). There are some lenders that go even further and lend up to 106% of a property's value to cover the purchase price and legal costs of a property however, this is usually only to borrowers with a sqeaky clean credit history and a demonstrated strong ability to service the debt - the interest rate is also usually higher to reflect the higher risk to the lender.
Australian lenders do not generally offer the same deep level of "Honeymoon" discounts as some US lenders have, which later cause repayment shock to borrowers when the "reality rate" later kicks in. Australian lenders do offer more gentle "Honeymoon Rates" usually about 1.5% below the standard rate and limited to the first 6 to 12 months of the loan, but assess the borrowers repayment capacity on the full interest rate (plus an additional "what if" rate buffer in many cases) rather than the deeply discounted or honeymoon rate scenario's as were the US experience. Therefore borrowers are usually able to cope with this increase in interest rates at the end of the honeymoon period.
The proportion of loans in Australia that are sub-prime remains very low, in the order of 1-2% of all mortgages in Australia whereas in the US, the sub-prime mortgage market constitutes approximately 17% of the current US mortgage market (up from 4% in 2003).
Mortgage delinquency rates in Australia reportedly still remain relatively low albeit there is more being reported in the media of late. According to a recent Moody’s report on the Australian residential mortgage market, delinquency rates, defined as mortgages 30 days past due, for all mortgages are currently at 1.26% for “FullDoc” lending and 2.03% for “LowDoc” lending. In the US, sub-prime 30 day past due rates are currently 9.45%.
Lenders in Australia have direct recourse against borrowers in the event of a default of the loan. Lenders can under powers contained in their mortgage documentation, obtain legal orders to declare borrowers bankrupt and seize other assets belonging to the borrower to recover any shortfall. In the US, barriers exist to prevent lenders pursuing borrowers to bankruptcy which essentially means that many borrowers can simply hand over the keys to their property and walk away and let the lenders wear any shortfall.
