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US Subprime Mortgage Meltdown And Its Impact on Australian Financial Market

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US Subprime Mortgage Meltdown

And Its Impact on Australian Financial Market (2007)

Ahmed Munawar

Lu Guangxi

Wang Ying

Zhao Hongxia

Contents

1.0 Introduction ........................................................................................................... 2

2.0 US Subprime Mortgage Market ............................................................................ 3

2. 1 The subprime meltdown ...................................................................................... 3

2. 2 Whom to be blamed? ........................................................................................ 4

2.3 The Effect on Australian financial system ......................................................... 6

3.1 Australian Share market .................................................................................... 6

3.2 Australian Hedge Fund Industry ....................................................................... 7

3.2.1 Basis Capital Limited ............................................................................... 9

3.2.2 Absolute Capital Limited ....................................................................... 10

3.2.3 Macquarie Fortress Funds ...................................................................... 10

3.3 Local Councils in Australia ............................................................................. 11

3.4 How have these financial sector affected in general? ..................................... 12

3.5 Australian Mortgage Market ........................................................................... 13

3.6 What are the safeguards and potential threats? ............................................... 15

4.0 Conclusion ........................................................................................................ 17


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1.0 Introduction

Since, mid July 2007 the ‘US subprime mortgage financial crisis’ has been a

common buzz heard in every financial centre all around the world as the crisis

spread throughout the world like a bush fire. Just as Das (2007) has stated, “It’s

like the old saying about chaos theory: the flapping of the wings of a butterfly in

the Amazon causes a Caribbean hurricane” and the contagion and the fallout

has just spread throughout the world.

The Australian stock exchange was also caught in the fire and some people

started expressing concerned because of globalised nature of financial

transactions that were carried out and given the rapid growth of mortgage

industry of Australia.

In this paper we have analyzed this question, firstly by having looked briefly into

the background to the mortgage crisis, followed by a detailed evaluation of the

impact on Australian hedge fund industry, the mortgage market and thereafter

reviewed some additional threats that are imposed and some safeguards that

are in discussion.


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2.0 US Subprime Mortgage Market

2. 1 The subprime meltdown

A subprime mortgage is simply a loan given to borrowers with low credit rating

and as such carries a very high interest rate. The Board of Governors of the

Federal Reserve System characterizes subprime borrowers as those who

display, among other characteristics, a low credit score, a previous record of

delinquency or foreclosure and a debt service-to-income ratio of 50 percent or

greater.

In the United States, during the 1990s one of the key financial developments

was the rapid expansion of subprime mortgage lending as a result of

liberalization in some government mortgage support programs, along with

desire for increased profits and significant technological innovations. Standard

and Poors estimated that the subprime originations totaled $421 billion which

according to Lewis (2007) represents about 16.8 percent of mortgage volume.

However, in mid 2006 the US subprime mortgage started melting down with

sharp rise in foreclosures; about 310,000 foreclosure proceedings were

initiated even in the fourth quarter and more than half accounted for subprime

mortgages. Two main factors attributed to the down fall in the markets.

Firstly, starting from June 2004, US Federal Reserve had increased interest


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rates thereby had made these adjustable rate mortgages (ARM) so expensive.

Similarly, after rising at an annual rate of nearly 9 percent from 2000 through

2005, the house prices had decelerated and even started falling thereby

making home owners unable to meet financial commitments.

2. 2 Whom to be blamed?

Some observes cast their blame on the practice of selling the CMOs

(collateralized mortgage obligations) with unbundled risks to a wide range of

investors seeking higher returns. In this way the banks are tempted to push

risky loans and the long-term risk to non-bank investors through debt

securitization. Many of such investors were hedge funds and investment banks

not only from US, but from all around world.

According to Bernanke (2007) with investor demand for such securities strong,

loosened underwriting standards is a major factor that had contributed to the

problems in the subprime sector. In addition, predatory lending practices and

outright fraud in a highly competitive lending environment is also partly to be

blame where mortgage brokers steered borrowers to unaffordable loans.

Christie (2007) pointed finger at regulators such as The Federal Reserve who

did not act soon enough and at the same time criticized borrowers who had

over-stated their incomes on loan applications and entered into loan

agreements they could not meet.


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With the sharp rise in foreclosures after the housing bubble, on 2 April New

Century Financial files for Chapter 11 bankruptcy protection followed by other

large mortgages lenders such American Home Mortgage Investment

Corporation and Accredited Home Lenders to shut down or file for bankruptcy

(BBC Business News, 2007).

However, the point at which meltdown spread beyond housing was when it took

a direct hit on two of the hedge funds exposed to subprime loans of the big

investment bank Bear Stearns, which went bust on 18 July 2007. Thereafter,

Wall Street investment banks and other financial institutions around the world

have also been affected and the list is so enormous. There is Goldman Sachs,

the UK based Cheyne Finance, the German Landesbank Sachsen, French

bank BNP Paribas and even in Australia’s own Macquarie were effected and

the list goes on. According to Ellis (2007), the cost of the subprime crisis

continues to mount on Wall Street and as of 8 October 2007 the direct cost was

estimated to be at nearly $20 billion.

On 27 July 2007 with worries of sub-prime crisis, the main US Dow Jones stock

index loses 4.2% in five sessions, its worst weekly decline in almost five years.

Similar losses were seen across the globe in stock markets worldwide such as

in London Stock Exchange, stock markets around the Pacific Rim with the likes

of Japan's Nikkei stock and Australia's benchmark indexes falling (Dougherty,

2007).


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2.3 The Effect on Australian financial system

With US economy and rest of the world hugely affected from the fall out of the

subprime market, many people were wondering if Australia also be affected.

Das (2007) believe that no one in the world is going to be immune from this

incident, and noted that it’s a question of degree rather than whether they’re

affected. Similarly, Roubini (2007), Professor of Stern School of Business, New

York thinks that “that when the US sneezes the rest of the world gets the cold

because the US is still one quarter of the global economy”.

With this down fall in US subprime market, Australian share market, hedge fund

industry, and mortgages industry was also affected. We will examine some of

the direct and indirect effects of the subprime mortgage e in Australia.

3.1 Australian Share market


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As seen from the above char, from June 2007 the Australian share market

plummeted with worries of the subprime meltdown in the US. On July 25, with

the dismal news from Wall Street the Australian share market opened about 1.2

per cent lower, with the banking and resources sectors hardest hit. By the end

of trading, the All Ordinaries Index was down 77 points, while the ASX 200 had

dropped 81 points. However, it was on August 2, the market suffered its biggest

shake-out since the aftermath of the September 11 terror attacks. With around

$50 billion wiped off the value of local stocks, the All Ordinaries index slumped

198 points to end at 5,989 which is a of drop of 3.2 per cent.

Against this backdrop, The Reserve Bank of Australia bought a total of A$905

million in securities on October 7, 2007 following its estimate of a daily financial

system deficit of A$633 million. Prior to this, similar moves were taken by the

European Central Bank (ECB) as they pumped over 205 billion U.S. Dollars in

the European financial markets while US Federal Reserve and the Bank of

Japan took similar steps

3.2 Australian Hedge Fund Industry

According to the recent report published by AXISS Australia, The Financial

Service Division of Invest Australia (2007) stated that the Australia’s hedge

fund industry worth of US$46.6bn1 has grown rapidly in recent years to

become the largest in Asia with the hedge fund managers in Australia control


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more assets than Hong Kong and Singapore put together.

As seen from above table, the growth of assets under managements by

Australian funds managers is also rapid as they have almost tripled in the past

two years.

The report by AXISS Australia (2007), The Hedge Funds Industry in Australia

stated further, that there are 66 hedge fund managers in Australia offering a

wide range of strategies including: This is indicated by the top ten hedge fund

managers listed below.


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Just like hedge funds around the world, some of Australian hedge funds had

also invested in the dodgy home loans and had then borrowed against their

investments. As a result, with the huge collapse of the subprime mortgages,

multi-billion dollar hedge funds in Australia had also been brought down one by

one. It started with Basis Capital collapsing followed by Absolute Capital and

even brought down Macquarie Fortress funds which had not been even

exposed to the subprime mortgages.

3.2.1 Basis Capital Limited

As one of the top Australian hedge fund leaders, Basis Capital was the first to

announce publicly in Asia to be affected by US subprime. In July 2007, the


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Basis Yield Alpha Fund informed its investors a drop of 14 percent in June.

According to the recent report on October 1 2007 Basis Capital to split hedge

fund, the $320 million Basis Yield Alpha Fund, which filed for bankruptcy

protection in the United States in August, has been placed in provisional

liquidation. Meanwhile, the $355 million Pac-Rim Opportunity Fund had lost

half its value on exposure to complex CDOs over US sub-prime mortgages.

3.2.2 Absolute Capital Limited

The Absolute Capital specializing in managing structured credit investments

has temporarily suspended its Yield Strategies Funds. The decision involves

the Absolute Capital Yield Strategies Fund and the Absolute Capital Yield

Strategies Fund NZD, which together have 200 million Australian dollars or

$177million under management. There will be no process for withdrawal

requests after 22 July until 25 October 2007.

As a guideline for investors, Absolute Capital believes the temporary closure is

the best way to protect the longer term interests of investors given the current

illiquid nature of the funds' investments.

3.2.3 Macquarie Fortress Funds

Being a retail arm of Australia's biggest investment bank, Macquarie Fortress

Investments invested its funds in senior secured US corporate loans. In mid


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July, when US subprime mortgage started falling, Macquarie Bank, managing

director Allan Moss says the trouble is concentrated at the risky and much

smaller end of the mortgage market and that its funds would not be effected

much.

However, he was proved to be wrong as on August 1 when they were exposed

to the subprime mortgage crisis in the United States. Two of its funds in

Fortress Investments faced up to 25 per cent or as much as $300-million as

potential losses. Macquarie's stock skidded 11 percent, its biggest one-day

drop in over five years on 1 August.

3.3 Local Councils in Australia

On September 9, 2007, some Australian council says they have been directly

affected by the fallout from the subprime mortgage crisis in the United States.

Even before this the Reserve Bank Governor had raised concerns about local

councils in Australia, investing in risky credit products built on the subprime

loans.

These councils have purchased products linked to the high-risk mortgages

from an investment company called Grange Securities and according to Mayor

of Manly Council in Sydney, Peter MacDonald that more than half of the

$500,000 his council invested has been wiped out by the subprime fallout on

Wall Street. Unlike private funds, these were tax payer’s money and as a result


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the New South Wales Government has ordered an audit of local councils (ABC

News, 2007)

3.4 How have these financial sector affected in general?

In the first case, with the fall of the hedge funds, the investors such

superannuation funds who had invested in these funds would be directly

affected as the hedge funds essentially vaporized and disappeared.

However, the biggest problem is stock markets all around the globe seems to

be a drying up of liquidity as the fear of default. According to Das (2007) “the

liquidity that’s flooded into the system is it’s gone nowhere. It’s just sitting there.

People have parked it in government securities because they’re terrified of

lending to anybody in case they won’t lend it”. He further added that “Once

credit markets seize up, fear, and it’s the fear of who you lend to, who you

transact with defaulting, becomes the paramount concern”.

As a result of this fear, share prices slumped in around the globe and the cost

of borrowing soared as credit markets re-priced risk across the board and it

has hit just about every form of debt such as corporate bonds, or even impact

the high quality end of the mortgage market.

The good news is that in fact few local managers have major exposure to US

sub-prime, since most of them focus on equity-related strategies. The


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domestic banking sector is unlikely to be hit either; with most of Basis’s

creditors being international (others include Lehman Brothers, Morgan Stanley

and Merrill Lynch).

3.5 Australian Mortgage Market

Wright (2007) said Australia has a sub-prime market as well and locally it is

called non-conforming housing loans but it is tiny compared with the US

industry.

According to the Reserve Bank of Australia, (March and September, 2007) as

seen from above table, non-conforming housing loans account for an

estimated 1% of all outstanding mortgages, which is well below the 15%

sub-prime share in the United States. The 90-day arrears rate on securitized

non-conforming loans has increased over the years to 5.25% in March while

by September it has risen to 7%, but stated that it is barely problematic at the

moment. Another relevant factor noted is that non-conforming loans in


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Australia usually do not feature low introductory interest rate periods or

high-risk repayment options such as negative amortization periods.

Reserve Bank however, admitted that from the securitization data those

borrowers who have taken out non-conforming loans and low-doc loans are

more likely to be experiencing repayment difficulties than borrowers with

standard loans. This is because the higher funding costs have caused a

number of providers of non-conforming loans to increase their rates by more

than the recent 25 basis point rise in the cash rate.

In addition, we have witnessed some mortgage related companies had been

affected directly and indirectly. On July 25, 2007, John West and Associates,

based at Campbelltown in Adelaide, with debts of more than $9.5 million

collapsed. Likewise, building materials company James Hardie warned on

August 15, that its profits too may be harmed by the subprime mortgage mess

in the US since 80 per cent of its sales is in the US.

Similarly, Rams Home Loans Group Ltd one of Australia's best-known

mortgage companies was in trouble in August as it failed to refinance A$6.17

billion ($5 billion) of short- term U.S. loans, forcing the lender to seek

emergency funding. However, Rams has not made any direct investments in

U.S. subprime mortgages and they are in trouble because of the uncertainty

gripping the United States. Rams shares also fell as much as 36% on the


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Australian Stock Exchange on August 16, 2007(Cochrane, 2007).

Ryan (2007) in an interview on ABC Local Radio on September 10 said that if

there is a recession in the world's biggest economy it would have an impact,

but unlike the US, the Australian economy is steaming ahead, and jobs are at

a 33-year low.

This can be confirmed when we looked to the Australian construction industry

as of October 2007. Craig O'Halloran Territory Construction Association says

there is enormous demand for housing right. The Australian Industry

Group-Housing Industry Association Performance of Construction Index

increased by 6.85 points to 55.2 in September, the strongest rate of growth

since June last year helped by improvement in house building, stronger

engineering and commercial activity.

3.6 What are the safeguards and potential threats?

On July 27, 2007, Federal treasurer Peter Costello said the nation's robust

credit standards would prevent a mortgage meltdown in Australia similar to the

one affecting the US sub-prime market. Mr Costello said stress tests by the

prudential regulator on Australian financial institutions showed they were

sound. "Our prudential regulations in Australia are better than in the United

States but we can't be complacent.”


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The Australian Securities and Investments Commission and the state and

territory governments regulate consumers, creditors and investors when it

comes to credit in Australia. But whether they do so sufficiently is now under

scrutiny. Treasurer Peter Costello in August called on the states and territories

this week to do more to regulate low documentation, or 'low-doc', lenders, who

may be pushing money on to people despite recognizing them as risky.

Meanwhile, the principal solicitor at Canberra's Care Financial Counseling

Service, Amy Kilpatrick, is just as scathing of the Commonwealth

Government's inaction over poor lending practices. She said Australia was

now facing a 'proliferation' of sub-prime lenders and lending standards had

been stretched as a result of Commonwealth policies. ''The Commonwealth

hasn't tasked anybody to look over the shoulders of any of the sub-prime

lenders to make sure they're doing the right thing”.

Despite such potential risks, speaking on ABC television, National Australia

Bank chief executive John Stewart said the Australian economy would largely

withstand any weakening in the US economy, he said. "The implications for

Australia luckily are quite small because there's no direct effect in Australia,"

he said. "We still don't think it will have a major effect on GDP (gross domestic

product) in Australia simply because our major trading partner right now is


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China and there is a huge trade with China."

4.0 Conclusion

It could be seen that Australia was not immune to the crisis as large losses

were made to some hedge funds operated and with Australian share market

taking a dive, almost all the financial institutions in the market has to some

extent been effected either directly or indirectly. The most obvious effect is that

credit has been re-priced all around the world and cost of borrowing has

increased as the liquidity in the global financial market has at some point dried

away and this in turn would effect to each and every individual.

In addition, the debt of the Australian has also been increasing at rapid speed.

Thus, even though the non-conforming housing loan in Australia is smaller,

there are damagers that if precautionary measures are not taken by all

responsible parties in the coming periods, the possibility of such an incident

occurring is there.


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