Sub-prime mortgage

HSBC has annouced its financial results last week (5/3/2007), indicating a profit warning due to its US lending units, one third of the group’s total earnings, that risk management and other controls are not meeting the expectations of with the group’s overall direction. The “specific” unit which Stephen green, chairman of HSBC holdings, was referring to the US mortgage business, which profit has substantially dropped due to the unexpected increase in delinquency in the sub-prime mortgage area. I am not going into too much details of what has already been announced, you can read them in http://www.hsbc.com/hsbc/news_room/news/news-archive-2007?cp=/public/groupsite/news_room/2007_archive/hsbc_holdings_plc_2006_annual_results.jhtml&isPc=true

or google it.

Anyway, reason I raised this topic, along side from the above, here are couple of articles I have read today:

1. US stock tempered by ongoing fears about sub-prime home lenders – US stocks lifted on Friday after a report showing solid jobs growth eased concerns about economic growth, but gains were tempered by ongoing fears about sub-prime home lenders.http://www.theage.com.au/news/BUSINESS/US-stocks-end-week-higher/2007/03/12/1173548056650.html
2. Sometimes you’ve got to be ready for a share of the pain – THERE’S a type of home loan you can get in the United States that has a fixed interest rate of 1 per cent for two years. It’s been rather popular apparently, especially at the “sub-prime” end of the market — that is, among people who have poor credit ratings.The catch is, the interest discount is capitalised (added to the loan) and at the end of the two years the rate goes to something approaching credit card rates. So there’s a double whammy: the loan gets bigger at the same time as the interest rate goes up — a lot. There was a boom in these two-year deals, er, two years ago. The Mortgage Bankers’ Association estimates that just over 35 per cent of all mortgages originated in 2005 were sub-prime, many on two-year honeymoons. http://www.theage.com.au/news/business/sometimes-youve-got-to-be-ready-for-a-share-of-the-pain/2007/03/06/1173166698913.html 
3. Regulator has also rasied concern with major banks tap into the sub-prime mortgage market to compete for the shares.

Enough said, you get the idea. Funny enough, why all the sudden the focus on sub-prime and why this hasn’t been “talked” about before until now.

This market wasn’t focused in the last couple of  years when the mortgage market still got enough breathe to have banks competing in it. Recently, the growth has slowed down and banks started to slice each other throats to get more market share in the “normal” area. What they then realised is that the sub-prime market, used to be focused by non-banks financial institutions, become their “final” resort of the mortgage market (pre-prime has been seen too risky to banks). Hence, big banks started to “throw in” resources to cut a slice of the cake, as much as possible.

You might ask, sub-prime mortgage is a risky business, and not all sub-prime mortgages are bad, shouldn’t bank has enough risk management control to manage it? There are three key areas as a causation:

1. Pricing – the compensation for bank to take up the risk is to increase the margin to cover the unsystematic risk. However, as in HSBC case, obviously they have mis-priced this section of the book. An increase in delinquency would increase the provision the banks need to hold, which ultimately affected the P&L. Unfortuately, sometimes bank would have to slice the margin to stay competitive.
2. Approval Decision – Big size of banks like HSBC, Citigroup etc., would have a decision tool system for loan approval, i.e. a bunch of business rules in the system to approve the loan, not by the bankers. This has been proven, from decision tools provider, that a higher quality of loan would be approved. However, for sub-prime mortgages, since it has only been a focus recently, there has not been enough “data” to come up a sophiscated rules to be built in the system (+ its costly and time consuming to upgrade the system). Hence, in most likely cases, it would be assessed manually by experience bankers. But unfortunately when the people above is looking for short-term target growth, the so call risk control and experience in this area is pretty much useless.
3. Data – As I have mentioned in #2, having a decision system in place will give valuable data. Unfortunately, without any precedent, it makes bank harder to “imagine” what the impact would really be like. On the other hand, most banks are pretty reactive in this area, i.e. they would only realise the delinquency rate has shot up when the data shows, and react accordingly. But then, its a “little bit” toooo late to cut down the loss. Not only that, most financial statements shows Impaired assets / Delinquency as of now, if you turn that into % of the loan book, for the past few years, it would be quite stable and low. But this figure has a flaw in it, that, it is low because the growth of the portfolio was faster than the delinquency. By the time the book has slowed down (like now) and effect of sub-prime, the bads would catch up eventually, faster than normal.

The end results of all the above, caused a concern to the consumer confidence when

1. A portion of the banks’ mortgage book is securitised by mortgage backed (mainly in US), sold by investment banks. The return has been nice in the past until now.
2. With an increase in delinquency, regulator will have a serious concern, as like NZ. Banks would also require to hold more provision and capital, or even restrict the credit. It would be harder and costly for consumer to borrow extra equity in their house.
3. Well, economic 101, business funding cost would increase, force the cost throwing back to consumer, inflation increase, bla bla bla, ends up slow in economic growth, may be even recession.

In conclusion, with all the directions are pointing one way for the mortgage market at the moment, banks would have a bumpy ride ahead of them.

 Welcome you guys tho