5th September 2007

Dear Investor,

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 so.

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:

  1. 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.

  2. 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.

  3. 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%.

  4. 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 higher rate.

  5. 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 Australia.

    In the US, the sub-prime mortgage market constitutes 17% (up from 4% in 2003) of the current US mortgage market.

  6. 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%.

  7. 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 assets.

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 volatile times.

Best regards,
Chris Andrews


> Home
> About Us
> PDS - Want to invest?
> FAQs
> Subscribe Free
> Independent Ratings
> Mortgage Shopping List

Chris Andrews
Head of Funds Management

t  +61 3 8610 2811
e  candrews@latrobefinancial.com.au

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.

Copyright 2010 La Trobe Financial. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial. Disclaimer

* La Trobe Financial Asset Management Limited ABN: 27 007 332 363 and AFSL No: 222213 is the issuer and manager of the La Trobe Australian Mortgage Fund. It is important for you to read the Product Disclosure Statement for the Fund before you make any investment decision. You can get a copy of the PDS by calling 1800 818 818. You should consider carefully whether or not investing in the Fund is appropriate for you.
(1) The rates of return from the Fund are not guaranteed and are determined by future revenue of the Fund, and may achieve lower than expected returns. Past performance is no guarantee of future performance. Investors risk losing some or all of their principal investment.
(2) Withdrawal rights are subject to liquidity and may be delayed or suspended.
(3) As at 30/11/10 the La Trobe Australian Mortgage Fund had received a Morningstar RatingTM of 5 stars. The Morningstar Rating is an assessment of a fund's past performance - based on both return and risk - which shows how similar investments compare with their competitors. A high rating alone is insufficient basis for an investment decision. © 2010 Morningstar, Inc. All rights reserved. Neither Morningstar, nor its affiliates nor their content providers guarantee the above data or content to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice has been prepared by Morningstar Australasia Pty Ltd ABN: 95 090 665 544, AFSL: 240892 (a subsidiary of Morningstar, Inc.), without reference to your objectives, financial situation or needs. You should consider the advice in light of these matters and, if applicable, the relevant product disclosure statement, before making any decision. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/fsg.pdf
(4) 3.75 star rating out of a possible 5 star rating indicates that Adviser Edge believes that La Trobe has performed in line with its peers and exceeded its peers on some fronts.
(5) The Standard and Poors rating of 4 out of 5 stars indicates that S + P has high conviction that La Trobe Financial will consistently generate risk-adjusted fund returns in excess of its relevant investment objectives and relative to its peers.
(6) The award was given to the La Trobe Australian Mortgage Fund, Pooled Mortgages Option.
Research Ratings are subject to change. To view the latest research information please visit www.adviseredge.com.au or www.standardandpoors.com.au. Ratings issued by Adviser Edge Investment Research AFS Licence No. 236783 and Standard & Poors Information Services (Australia) Pty Ltd AFS Licence No. 258896 are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. The ratings are only one factor to be taken into account in deciding to invest. Research Houses receive a fee from La Trobe for rating the product. The Adviser Edge rating is generally a measure of the rated entity's capacity to meet its repayment obligations in all market circumstances.
IMPORTANT: This message, together with the La Trobe Financial website (www.latrobefinancial.com.au) and all its contents have been prepared for general information only and should not be taken as legal or financial advice, and as such the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore talk with their financial planner or advisor before acting on any information present on this message or the La Trobe website.