• 
• 

Published on September 26, 2007

Over the past several months, the business airwaves have been bombarded by news of massive US sub-prime real-estate loans generating losses at global financial institutions.

Prior to this period, many of us in Asia had never heard the term "sub-prime loan", and most of us still don't understand how defaulting sub-prime US real-estate loans could possibly affect financial institutions in Thailand.

Russell Toy, an American certified public accountant and currently Global Financial Services Industry country leader and a partner in Deloitte Thailand, said sub-prime loans in the US were loans that top-tier banks in the US would normally not underwrite. "These loans were primarily issued by huge independent mortgage companies scattered throughout the US," he said.

As the US real-estate market continued reaching new highs over the past several years, many lenders became bullish and cut their home-loan qualification requirements. "Loan-to-value ratios were increased, and loan payments often included short-term low-payment teaser rates."

In a fast-rising real-estate environment featuring low-interest rates and rising sale prices, these financial institutions and buyers presumed they faced minimal risks. But when interest rates began rising, and prices began stagnating, many of these loans quickly turned sour. "Even at the real-estate market's peak, many borrowers could barely make the payments at the teaser rates," Toy said.

Toy explained that teaser-rate loans were often adjustable-rate mortgages fixed for a short period at an artificially low rate and would revert to market interest rates when the loans were readjusted.

"Most teaser-rate loans didn't include any amortisation," he said.

Sub-prime loan borrowers faced a double-whammy when the current US real-estate market began slowing.

"First of all, they had initially received high loan-to-value-ratio loans, often up to 95 per cent of purchase price," Toy said. "As the real-estate market began tanking, many  loans were underwater, because the debt exceeded a home's market value."

Second, as interest rates rose, the adjustable-rate mortgages had to be readjusted to higher rates. Many borrowers had great difficulty making the new payments."Their new loan payments in most cases had higher interest rates and would also include amortisation payments."

If the US real-estate market had continued on its previous up-trend, many of these sub-prime borrowers would have sought new teaser-rate loans or sold their homes for a profit.

"The falling real-estate market took away these options," Toy said.

In the past, real-estate financing was primarily issued by local or regional financial institutions. These institutions would inspect the properties and evaluate the borrowers before issuing mortgages. "They would then hold these loans on their books," Toy said.

But in the past decade, the housing-loan environment underwent a monumental change, beginning in the US. Many financial institutions and mortgage lenders were able to package their home loans as securities that were sold to investors all over the world.

Huge pools of home loans, including sub-prime, were combined, and securities, often rated AAA, were issued to savvy global investors. As of June, an estimated US$10.2 trillion (Bt349 trillion) worth of such securities were outstanding in the US. Sub-prime loans were estimated to constitute about 13 per cent, or $1.3 trillion.

As the US securitisation market developed, investment bankers continued developing new products for developers and home-buyers. As the rising US property market reached its peak, developers and agents began selling more homes to sub-prime lenders.

"Near the end, many of these sub-prime borrowers had tainted credit histories," said Toy.

As a result, many questionable types of home loans were bundled into many classes of securities and sold by investment banks globally. These investors included Thai financial institutions.

Part two: How can highly rated bonds become virtually worthless in today's sub-prime environment?