5th September 2007
US sub prime market – What is it and why does it matter?
What is the US sub prime market?
The “US sub prime market” is a part of the residential mortgage market in the US and is characterised by low income
borrowers who have a bad credit history in servicing their home loans. In 2005, the United States real estate market
experienced an all time high and as part of this, financing became more creative to make owning a home more
accessible to the wider population - in particular, to those who may not have otherwise been able to afford to do
Characteristics of the changes in lending practices included:
- Credit became available to low income members of the community with a poor credit history, who are
known as ‘sub prime borrowers’.
- Low-start and teaser rate loans – the ‘catch’ to these types of loans was that they included an interest
rate reset condition that doubled the initial loan rate after a short period of time.
- Honeymoon rates – Some initial interest rates were as low as 1% to 2% for the first two years then they
increased to the standard rate of 7% pa. This caused sub prime borrowers to default as they could not keep
up with the repayments on their loans.
- High Loan to Value Ratios (“LVRs”) – some as high as 140%. Traditionally, LVRs do not usually exceed 80%.
As property prices began to fall, this made the position of the sub prime borrower even worse.
Therefore, as the interest rates increased on these types of loans, many sub prime borrowers could not meet on their
repayments, and so defaulted on their loans. It is now believed that up to 7 million people in the US have taken out
sub prime mortgages.
Why has this fallout in the US sub prime market affected other markets around the world?
The crisis spread because many sub prime mortgages in the US have been “packaged” by lenders with the help of
investment banks and sold around the world to financial institutions and hedge fund managers. These packages are
often referred to as ‘Collateralised Debt Obligations’ (“CDOs”).
In basic terms, as the value in the US real estate market began to decrease and the level of defaults began to
increase, the investments in these CDOs became non viable to the point where many major investors lost substantial
amounts of money. Two Australian fund managers who have been affected are Basis Capital and Macquarie Bank through
its Fortress Products.
There has been some concern that the Australian mortgage market may follow suit. However in Australia there are
significant differences, so that it is unlikely that the negative impact will flow into Australia.
What is La Trobe’s position and what are the differences?
Because of La Trobe’s approach to lending, the problems experienced in the US sub prime market should not affect La
Trobe or its borrowers, for the following reasons:
- The basis of funding the underlying loans is different
La Trobe’s loans have neither been packaged in the way the US loans have been nor have they been funded by the US
capital markets, so La Trobe is not directly exposed to this specific risk in the broader financial markets. In
the US, most mortgages are issued on a fixed 15 or 30 year mortgage basis, while the underlying funding is from
short term capital markets debt paper.
La Trobe is not directly exposed to the US capital markets.
- Borrower capacity testing
La Trobe does not lend to sub-prime borrowers, and assesses the capacity of borrowers to service their loan
commitments by obtaining (depending on the circumstances) a combination of:
- an independent credit check on the borrower;
- a letter from the borrower’s accountant confirming the borrower’s repayment ability; and
- a repayment declaration from the borrower.
In the US, they have been lending to borrowers who are known as NINJAs – No Income, No Jobs, No Assets.
- Loan to Value Ratio (“LVR”)
Generally, the LVR that La Trobe applies is 66%, up to a maximum of 80%.
In the US, LVRs frequently exceed 80% and can be as high as 140%.
- Honeymoon Rates or Reset Clauses
La Trobe loans do not use any borrower ‘reset clauses’ with deep discounts causing repayment shock to borrowers.
La Trobe does offer to some borrowers a Honeymoon Rate loan which is currently only 1.5% below the standard rate and is limited
to the first 6 to 12 months of the loan. But a compelling difference is La Trobe's borrower repayment capacity is tested on the full interest
rate rather than the discounted or honeymoon rate. We find therefore that borrowers are more than
able to cope with this increase in interest rates at the end of the honeymoon period. It is important to note
however that La Trobe’s Mortgage Fund does not offer honeymoon rate loans.
In the US, borrowers were assessed on the lower discount rate and the discounts were often 3% for the first two
years (a much longer discount rate than Australia). After 2 years, the rate increased substantially. These loans
are known as “2/28” loans, where the first 2 years was on the discount rate and the next 28 years were on the much
- The proportion of loans that are sub-prime
The proportion of loans in Australia that are sub-prime remains very low, in the order of 1-2% of all mortgages
In the US, the sub-prime mortgage market constitutes 17% (up from 4% in 2003) of the current US mortgage
- Delinquency rates are very low in Australia
Mortgage delinquency rates in Australia still remain very low. According to a recent Moody’s report on the
Australian residential mortgage market, delinquency rates, defined as mortgages 30 days past due, for all
mortgages are currently at 1.26% for “full doc” lending and 2.03% for “low doc” lending.
In the US, sub prime 30 day past due rates are currently 9.45%.
- Recourse to the borrower
Lenders in Australia have direct recourse against the borrower in the event of a default of the loan.
Lenders can obtain legal orders to declare the borrower bankrupt and seize other assets belonging to the
borrower to recover any shortfall.
In the US, significant difficulties exist to prevent lenders obtaining the bankruptcy of borrowers and many
mortgages do not have personal covenants allowing lenders to proceed directly against borrowers and their
La Trobe’s track record
Since La Trobe’s inception in 1952, it has raised over A$9.3 billion to assist over 96,000 borrowing customers.
La Trobe has successfully managed mortgage lending through difficult economic times such as the rebuilding period
post war and more recently the 1980s and early 1990s during the recession ‘Australia had to have’. La Trobe prides
itself on its responsible lending practices, which has made it the only wholly owned Australian mortgage provider
consistently managing Australian mortgages over the past 54 years. Suffice it to say, La Trobe has a comprehensive
knowledge of the Australian mortgage industry and the skills to manage your investments and mortgages during
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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