Views on the US sub-prime impact on SA

Posted On Wednesday, 10 October 2007 02:00 Published by
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Property Innovation, complied by Madison Property Fund Managers, provides some comments from sector opinion makers on the sub-prime and related challenges currently facing property

David Shapiro, Sasfin

The JSE is trading within touching distance of its all-time peak reached mid-July. President Bush's plan to help creditworthy homeowners refinance their mortgages, Federal Reserve Bank Chairman Bernanke's decision to reduce interest rates for the first time in four years and central bankers extensive aid to money markets restored hope in financial markets that a major economic crisis, developing from losses in the sub-prime market, would be averted.

Stock markets recovered sharply, but, within days, investors' preoccupation with the slump in the US housing market and worries over the consequences of tight credit markets on consumer spending put a cap on the gains. The US dollar collapsed on the belief that Bernanke would cut rates further and investors seeking  safe havens turned their attention to the metal markets, pushing gold to fresh 26 year highs. Local resource shares boomed helping lift the JSE to its current lofty level.

Initially the broad view was that the fallout from the sub-prime crisis would be contained and would have minimal impact on the real economy. But if bankers become too guarded, limiting loans or unduly raising interest rates to dependable businesses and responsible consumers, then the squeeze, that originated from weakness in the US housing market, could easily spread to other areas of economic activity.

The source of the markets' troubles goes back to the 2000/1 when interest rates were cut dramatically by US Federal Reserve Chairman, Alan Greenspan, in an exercise to restore consumer confidence in the aftermath of the Internet crash, the attack on The World Trade Center and a sequence of business scams. The rapid expansion that followed attracted large inflows of money from investors in search of cheap assets. Further funds flowed in from emerging Asia and, later, from the massive surpluses earned by the oil exporting nations.

The UK, Europe and Japan followed by example pumping money into their economies. Inflation eased, corporate profits swelled. Cheap money was abundant and investment banks, mortgage originators, hedge funds and other business promoters took full advantage of the benign environment.

Investors, still bearing the scars of a battered stock market, revived their interest in property. With interest rates at historical lows, housing activity exploded. Real estate prices rose rapidly and owners, quick to respond, cashed-in the increase taking out additional mortgages, either consuming the proceeds or spending the amount on second or third properties. As long as prices kept rising property investment was a "no brainer".

The belief that properties could always be passed on at a profit to a devouring market accelerated growth in sub-prime loans; mortgages to borrowers who normally would not have qualified because of a poor credit history or the inability to support monthly payments. Between 20% and 30% of new mortgages granted in the past few years across all states in the US were of sub-prime quality.

But originators had no fear. Mortgages were very good performing securities and were in huge demand Loans of all types and shapes were bundled into securities and sold off to hedge funds and other investment managers.

As the popularity for these instruments grew, credit granting procedures were relaxed in the knowledge that the loans would be packaged and passed on to large institutional buyers, creating the illusion that risk was being spread widely.
A considerable number of these mortgages were issued with enticing teasers, such as low initial interest rates that would reset three to five years down the line. As interest rates began to rise and the preliminary period terminated, problems began to emerge.

As delinquencies increased in the sub-prime market and rates across all classes of home loans were reset, lenders grew reluctant to part with their capital, unsure of the quality and characteristics of the security provided. Even reputable buyers found it more difficult to raise finance, a situation that forced interest rates higher on all kinds of borrowing.
Central bankers are doing all they can to reassure markets, short of reducing interest rates. Money is being poured into the banking system in return for which the central bankers are prepared to accept any category of collateral. No one is sure when the turmoil will end or what the eventual costs to global growth will amount to. Until then investors will continue to tread warily, unwilling to commit too much to a turnaround in financial markets. When down-payments for property purchases become standard and buyers can sustain their monthly payments, markets may return to normal.
Anton de Goede, Investec Listed Property Investments

One of the key drivers behind the sub-prime mortgage financial crisis is the repricing of risk in the financial markets. The practice of sub-prime mortgage lending, focusing on borrowers with a poor credit record, in the US has increased substantially since 2003, currently making up between 15% and 20% of the total US mortgage market.
As the traditional prime home loan market became saturated, lending institutions saw the sub-prime segment as an untapped potential market to sustain revenue growth, especially in a historical low interest rate environment. Lending products were developed with lower underwriting standards, extra long-term or interest only mortgages, hybrid structures layering risk or underwriting without any documentation.

With the financial markets awash with liquidity, global investors searched for higher yielding instruments, especially since real global interest rates were at very low levels. Investment banks utilized this appetite through repackaging these non-investment grade sub-prime mortgages into liquid investment graded residential mortgage back securities and even further into collateralized debt obligations.

Although the underlying risk of sub-prime mortgages remained the same, credit rating agencies warranted these gradings on the back of the diversification benefits of pooling these mortgages together.

However, with the 17 consecutive interest rate increases in the US and a softer housing market, with house price growth turning negative, the dynamics of the sub-prime market have changed, making such diversification benefits of little or no value. An increase in loan foreclosures and defaults within the current housing market and interest rate environment, as little or even negative equity is left to refinance these hybrid loan structures, have resulted in many of the securitized instruments being downgraded and losing capital value, with the risk of full capital loss increasing.

Besides US investment banks and hedge funds, mostly European and Asian financial institutions are invested into these securitized sub-prime instruments. Local banks and hedge funds have limited, if any, exposure to these instruments. The prevalence of sub-prime mortgage lending has also never been significant in South Africa. The introduction of the National Credit Act this year has made lending criteria even more stringent, with available disposable income becoming a key determinant.

The risk does exist that the softer housing market and subsequent sub-prime crisis may negatively influence US economic growth. American consumers took advantage of the strong housing market of the last few years to use the increased house values to refinance against these higher values and using the excess cash from the loans to finance their discretionary spending patterns. Although these equity withdrawals have in the recent past always been responsible for a portion of GDP growth, the percentage contribution has increased since 2001 to between 50% and 80%.

The dependence of Asian and European economies, which have been the main provider of consumer goods to the US, on this consumer spending has left specifically Asian stock markets at the mercy of the roller coaster market sentiment pertaining to the potential impact of the sub-prime crisis.

South African exports are not as dependent on the American consumer. Europe and Asia remain our biggest export markets, and sluggish American consumer spending should thus not impact our manufacturing sector.

South Africa is however not entirely out of the woods if the sub-prime crisis multiplies into a substantial US economic slowdown. As an emerging market investment destination, the re-pricing of risk may result in less foreign capital market inflows which have been financing our current account deficit. Also, as slower US economic growth should lead to a slowdown in Asian manufacturing, the demand for natural resources may wane, putting pressure on the rand and our stock market.


Prof Francois Viruly, University of the Witwatersrand

In assessing why the US sub-prime mortgage crisis did not have a greater impact on the South African economy two points need specific consideration. The US subprime crisis was to some degree the result of negligent lending by US banks and mortgage originators, combined with the introduction of financial instruments that permitted risk to be transferred to third parties.
Foreign banks with a strong exposure to this US market were tainted by the fallout that ensued. With the South African banking sector having a negligible exposure to the US sub prime market, the financial liquidity problem that developed in the US and Europe markets, was never perceived an issue in South Africa.  Yet, indirectly South Africa did feel the global impact through the performance of the JSE.

The question is whether such a crisis could occur in South Africa. There is a risk that the South African home loan environment could be showing some of characteristics and symptoms that led to the US scenario.

In the US, the problem was largely a function of the decision by financial institutions to promote home
ownership to marginal households. In the past decade, US financial institutions responded to laws against discriminatory lending practices and a commitment to promote home ownership by lower income households.

But, marginal bond holders usually come with a higher risk profile. In the past, the strong performance of the residential property market meant that the default risk was insignificant, with most households experiencing a rapid growth in home asset value. The scenario became of greater concern once the residential market showed signs of slowing.

In South Africa, the financial charter is placing growing pressure on the banking sector to enter potentially riskier markets. Such policies reflect a changing social environment with a growing middle class being encouraged to enter the housing market.  But, the National Credit Act offers the opportunity of ensuring that those who enter the residential market do so on a strong footing.  The relatively strong growth of the South African middle class suggests that the exposure that banks have to this sector will grow in time.

Lending to marginal households could however lead to a South African sub-prime problem should interest rates continue to rise, resulting in a strong downturn in the South African residential property cycle. 

Publisher: Madison Property Fund Managers
Source: Various Contributors

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