The Hindu Business Line : Mortgage woes

The financial markets can be cruel. It does not matter if you are a borrower, lender or an investor, you could lose a lot of money in the market, as the participants in the US sub-prime mortgage market have found in recent times. What is this market and how does it impact investors?

Sub-prime market refers to home loans given to borrowers who have poor credit or those who do not have enough income. As such, loans are given at a floating rate, the borrowers are at the mercy of the Federal Reserve — the US central bank. Why?

The Federal Reserve can increase the Fed Funds rate — the rate at which one financial institution borrows from another — if it believes inflation is high. When the central bank increases the Fed Funds rate, all financial institutions hike their lending rates. And that pushes up borrowing rate on floating-rate loans.

Rising rates, falling prices

Since June 2004, the central bank has increased this rate 17 times. When borrowing rates are high, housing demand falls. And that translates into lower housing prices. The result? Sub-prime borrowers are faced with rising interest rates and falling property prices.

Naturally, defaults on such loans have gone up in recent times, forcing many sub-prime mortgage lenders to close shop. That is not all. Mortgage loans in the US are typically bundled off into securities (called mortgage-backed securities) and sold to investors in the market. Defaults on mortgage loans mean losses to these investors.

Some experts worry on the impact these losses will have on Wall Street. Others shrug it off, arguing that such defaults are small in comparison to the total market. Whatever the outcome, one thing is certain: Sub-prime borrowers, lenders and investors are hurt.

(The author is based in Surrey, BC, Canada.)

More Stories on : Mortgage | Stock Markets | Simple Economics

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page