Home Loans: The mortgage market

An understanding of the mortgage market is relevant in today’s economic scenario. The important practice of lending or loans for purchase of residences is the basis for many home buyers to become home owners. Among the usual home loans that are commonly taken, sub prime lending is the main cause for the bursting of the housing bubble in United States. Sub prime lending is the extending of home loans to people who would normally not meet the criteria or are not eligible to get a loan at the lowest prevailing market rate of interest. The eligibility is decided on by the borrower’s credit score, credit history etc. In the event of default the lenders can take possession of the borrower’s home through foreclosure procedures.

When the borrower has an option to default, credit risk arises. Normally the credit risk is borne by lenders. But over the years lenders have acquired the right to receive payments through the process of securitization. The securities thus acquired are called mortgage backed securities (MBS) and collateral debt obligations (CDO). Lenders who have MBS and CDOs are also under certain types of risks. The first is the credit risk which gives the borrower the choice of not paying the loan back. Secondly, the assets like the MBS might depreciate in value over years. This would result in financial losses for the lender. Thirdly, there is the liquidity risk where in the business entity might not get financing. Finally, counterparty risk which is when the party does not oblige the contract.

Cumulative effects of these risks led to caution exercised by the lenders while the issuing of home loans. The recent years have seen the effect of these risks magnified by high debt levels in households and businesses. The American home loans and risks have a global impact since MBS and CDOs initiate integration of the markets here with global financial markets. The systemic risk thus arising would damage the entire financial system.

As a protection against default, the MBS and CDO lenders can avail credit defaults swap (CDS). This also was not able to counter the uncertainty that is prevalent in the housing market.  The inability of home owners to repay home loans, lack of judgment by borrowers and lenders, speculation led investments during boom time, high percentage of personal and corporate debts, monetary policy of the government, pseudo risk posed by mortgage default and financial products sold through this and moral hazards were mainly responsible for the present situation.

The sub prime mortgages were estimated at $1.3 trillion in March 2007. The delinquency rate had tripled from the year 2005 and by January 2008 the rate had risen to 21% and by December 2008 it was at a scaring 35%. Sub prime adjustable rate of mortgage (ARM) were 90 days and more delinquent and the lender had started the process of foreclosures. Almost 940,500 residences in USA were foreclosed in the year 2008 – 2009.

The mortgage market is facing a grim situation and the end is nowhere in sight. Government policies are being amended to bail the common borrower and the unfortunate lenders from this quick sand.