Lucky Fiakpa, Adekunle Adekoya, Hector Igbikiowubo, Babajide Komolafe
13 October 2008
The market fundamentals of the Nigerian capital market are strong with many quoted companies still posting mouthwatering profits.
However, Lucky Fiakpa, Adekunle Adekoya, Hector Igbikiowubo, Babajide Komolafe report that the external shocks of the global financial meltdown on the prices of listed stocks have been very telling putting many investors in distress
What actually caused the on-going global financial crisis? The crisis has its root in a banking practice called sub-prime lending or sub-prime mortgage lending in the United States. A mortgage is a long-term loan that is designed to make home ownership more affordable.
In the U.S there are three types of mortgages namely Conventional, Interest Only and Sub-prime. In conventional mortgages, part of each month's payment goes towards paying off the principal and part goes toward interest. Conventional mortgages include fixed rate mortgages, where the interest rate is the same throughout the life of the loan, or adjustable rate mortgages, where the interest rate can vary.
In an interest-only loan or mortgage the borrower only pays interest each month. This makes it cheaper than a conventional mortgage, where part of each month's payment go towards the principal and part goes towards interest.
Sub-prime mortgage is granted to borrowers whose credit history is not sufficient to get a conventional mortgage or who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status.
When banks book these mortgages or loans, they package them into Mortgage Backed Securities (MBS), sell them to two institutions known as Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). The two institutions were created by the U.S government in 1968 for the purpose of to buying off MBS from banks.
The intent was to allow banks to sell off mortgages, thus freeing up funds to lend to more prospective homeowners. But this removes one constraint on banks which is to make sure the loans are to qualified borrowers. These two institutions in turn repackage the loans and sell them to investors and financial institutions around the world.
Banks usually hire sophisticated "quant jocks" who wrote computer programmes that could repackage these MBS into high risk and low risk product bundles. The computer programmes were so complicated that no one really understood what exactly was in each product bundle or how much of the bundle had sub-prime mortgages. When times were good, it didn't matter, and everyone bought the high risk bundles because they gave a higher return. As the housing market declined, however, everyone knew that these products were losing value but, since no one other than the computer programmes understood them, the resale value of the products was unclear.
Also many of those who purchased these MBS were not just other banks, but individual investors, pension funds and hedge funds. This meant that the risk was spread throughout the economy.
Between 1994 and 2004 the U.S Housing market experienced persistent boom fueled by a host of factors, chiefly sub-prime borrowing. During this period sub-prime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home-ownership rate increased from 64 per cent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 per cent.
One factor for this trend was that during boom years, mortgage brokers enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks.
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124 per cent .Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130 per cent during 2007, versus 100 per cent earlier in the decade.
However, by 2006, a number of factors like, the rising gasoline prices, the Huricane Katrina, the War in Iraq and Afganistan, outsourcing and the rising food price due to the global food crisis, led to rising unemployment and decline in business activities. This macroeconomic turbulence translated to increasing default by home owners hence increasing foreclosure rates. Rising foreclosure rates coupled with over building during the boom years led to an over rising housing inventories i.e.
excess supply of housing, and these in turn led to decline in housing prices. Once housing prices started depreciating moderately in many parts of the U.S., refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts. Other homeowners, facing declines in home market value or with limited accumulated equity, chose to stop paying their mortgage. They were essentially "walking away" from the property and allowing foreclosure.
Pertinent to these is that most of the default or foreclosures were sub-prime mortgages. While as at March 2006 the value of U.S. sub-prime mortgages was estimated at $1.3 trillion as at March 2007, 16 per cent of these loans were 90-days delinquent or in foreclosure proceedings as of October 2007. By January 2008, the delinquency rate had risen to 21 per cent and by May 2008 it was 25 per cent. Though sub-prime only represent 6.8 percent of the loans outstanding in the U.S, yet they represent 43.0 per cent of the foreclosures during the third quarter of 2007.
As indicated above mortgages are repackaged as MBS and sold to financial institutions (banks, hedge funds) and investors around the world. The import is that many investors and institutions around the world became exposed to the U.S housing market especially the sub-prime mortgages. The mass default of sub-prime mortgage debtors meant that the MBS became bad loans in the books of banks, financial institutions and investors who bought these securities. The bad loans led to huge lose by banks and financial institutions and eventual collapse of some of them.
With MBS becoming bad loans, banks became unwilling to lend to each other, afraid that they would receive bad MBS in return. No one knew how much bad debt they had on their books, and no one wanted to admit it. If they did, then their credit rating would be lowered, their stock price would fall, and they would be unable to raise more funds to stay in business.
Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of May 21, 2008 financial institutions had recognized sub-prime related losses and write-downs exceeding $379 billion.
In fact, profits at the 8,533 U.S. banks insured by the Federal Deposit Insurance Corporation (FDIC) declined from $35.2 billion to $646 million i.e. 89 per cent during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007, these banks earned approximately $100 billion, down 31 per cent from a record profit of $145 billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year, a decline of 46 per cent.
Other companies from around the world, such as IKB Deutsche Industriebank, have also suffered significant losses and scores of mortgage lenders have filed for bankruptcy. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other. Various institutions followed with merger deals.
In addition, Northern Rock and Bear Stearns have required emergency assistance from central banks. IndyMac was shut down by the FDIC on July 11, 2008. The crisis also affected banks from other countries which have ventured into USA. For example ICICI, India's second largest bank, has reported mark-to-market loss of $263 million in its loans and investment exposures. Other state owned banks such as State Bank of India, Bank of India and Bank of Baroda have refused to release their figures. At least 100 mortgage companies have either shut down, suspended operations or been sold since 2007.
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