US lenders relearn the rules of risk

Ground Floor: We've had "concerns about the Chinese economy" story and the "yen carry trade" story and now, to further explain the current stock market volatility, we've got the "sub-prime lending" story. It is the US mortgage market that is exercising people's minds.

Sub-prime is one of those technical-sounding terms for what is actually risky lending. If you have loans on a balance sheet which are characterised as risky lending, you run the equal risk of scaring off the investors. Basically, however, sub-prime lending means extending credit to people who have a shaky credit history or whose income would normally disqualify them from being able to borrow.

The sub-prime market in the US was one of the fastest- growing segments of the mortgage market a couple of years ago. Banks, awash with cash and looking for a decent return on the money (after all, interest rates were at historically low levels), cast their nets a bit wider and decided that lending to people they would normally ignore was a great idea. Not only that, but they initiated the lending with some very attractive rates.

Typically, a borrower who would normally score badly on the lending criteria range would be offered a special deal for the first year or so of the mortgage.

Then rates would be marked significantly higher, although theoretically still within the borrower's ability to repay.

Sometimes the borrower would be encouraged to refinance the mortgage in order to avail of another low-interest rate deal and sometimes they would also borrower higher amounts on refinancing based on the strong property market.

However multiple increases by the Fed have pushed rates higher still, the property market has slumped and sub-prime borrowers, without additional resources to fall back on, have been defaulting on their loans.

One of the catalysts for the current round of market nervousness was when HSBC Finance said it was increasing its provision for bad debts by 20 per cent more than analysts had forecast because of problems with the US mortgage market.

Then New Century Financial, the second-largest sub-prime mortgage lender in the US, said it would restate its results for the first three quarters of 2006 on the back of "accounting errors" related to mortgage losses. It also announced an expected loss for the final quarter due to defaults.

In December 2004, New Century was a market darling with a share price of $65.95. As property market began to decline so did the share price.

Now US prosecutors have opened an investigation into its securities trading as the stock continues to plummet while subpoenas have been issued in relation to a number analysts' valuations of sub-prime lenders. New Century stock is currently about $14 and the company is not writing any more new loans.

Generally, you would think this is a problem for New Century and for everyone else in the sub-prime market, that it's not a problem which should affect the wider financial environment. Unfortunately there's a little more to it than that. Many lenders secure their loans and then sell them on to other financial institutions, thus extending the risk elsewhere.

For most big banks with a wide variety of business, this is not cataclysmic although it certainly rattles the bottom line - and investors don't like to see the bottom line of financial institutions being rattled too much. Banks are generally supposed to make money, not lose it. Then again they are also supposed to assess credit risk and not lend money hand over fist to people who will struggle to repay it as soon as the interest rate environment changes even slightly.

The thing is, when the mortgage market is doing well, when rates are low and house prices rising steadily, the quality of the borrower is not that much of a issue. After all, if the bank needs to foreclose, the value of the property is going to be vastly higher than the outstanding loan. It's the opposite scenario that causes problems, a falling property market and a loan greater than the value of the property.

Clearly none of this is rocket science, the banks are well aware of it and they reckon that they can hack some defaults, but when investors start worrying about it, then the banks do too.

The stock market is looking at this as a problem for the financial institutions which can seep into the wider economy and that's why it is rattled.

However, there is more than just an economic problem for the US. Many of them have used sub-prime loans to consolidate their entire household debt and borrow some extra money too, all based on the value of their homes. Now their properties are worth less, interest rates are going up and more and more are defaulting on their loans, leaving them homeless and, in some cases, bankrupt.

The global property market has been the driver of much of the prosperity of western economies over the past decade. Because of its importance, analysts have frequently talked about the "soft landing" as being welcome and necessary.

Unfortunately the landing for the US market is a lot bumpier than they would have liked. The recently published Mortgage Banker's Association National Delinquency Survey shows that 13.3 per cent of sub-prime mortgages were delinquent in the last quarter of 2006. Moody's estimates that there will be 400,000 foreclosures for 2006 and that this will double for 2007.

None of this is good news. Economic prosperity built on the shifting sands of people who can ill afford to pay for credit is not real prosperity, but we're supposed to know that, aren't we?