Rumours have been circulating about the brewing subprime mortgage crisis for the past 18 months or so. More recently we have seen these rumours explode into major headlines as the global effects of the fallout from the US subprime mortgage predicament are felt. Although we should all by now be familiar with the term ‘subprime mortgage lender’, not all of us know what these lenders are. Even more so, many of us fail to see how problems with relating to US subprime mortgage lenders affect global markets.
Subprime lenders traditionally operate outside general ‘prime’ lending conventions. They provide credit to individuals with bad credit ratings, few assets and low incomes. In the US, there have been instances of lending institutions selling ‘Ninja’ mortgages – meaning to people with no income, no job and no assets. Many also allow mortgage applicants to self-certify, in that they personally certify their own level of earnings. In return for this, they charge interest at a much higher level than prime lenders. These lenders then put the loans into bundles and sell off the risk on the credit markets. Another investor will buy this bundle of loans and the return on their investment is the high rates of interest that they are receiving as borrowers pay off their loans. The flip side of this is that subprime mortgages come with a high level of risk as there is an increased chance of the mortgage being defaulted upon. This is the major problem behind the US subprime mortgage market. Lenders became reckless with their lending methods and this recklessness resulted in a huge amount of defaults as loans were granted to unsuitable and financially incapable applicants.
During the week, BNP Paribas announced that it had frozen three of its hedge funds, totalling around €1.6 billion. The bank declared that a complete “evaporation of liquidity” was the reason for this action and that it was now impossible to value units within the funds as they were affected by the US subprime lending market. This is because the funds were partly made up of bundles of subprime loans, demand for which had fallen as banks lost confidence in each other. Nobody wants to buy packages of subprime loans which are being defaulted upon.
Last week saw scenes of chaos in the global banking sector as banks feared that they may not have access to sufficient cash to sustain day-to-day lending and business obligations. The announcement by BNP Paribas, one of the largest eurozone banks, added fuel to the fire. Jean-Claude Trichet of the ECB went to extraordinary lengths to attempt to alleviate the pressure on banks, injecting €95 billion into the banking system on Thursday and over €60 billion on Friday. These measures are not life-savers however, but are simply an aid to short-term liquidity problems.
Investors panicked and began to back out of financial markets, fearing that over exposure to the subprime market and heavy reliance on housing markets was instable. Irish markets were particularly affected by this as the four major banks (AIB, Anglo-Irish bank, IL&P and BOI) are the main pillars of the Irish market. Unless confidence is restored in investors in the near future, there may be more hard times ahead for those in the global banking sector and will doubtless see more ECB interventions attempting to resuscitate floundering European banks.