Subprime Mortgages — February 2008

The U.S. sub-prime mortgage crisis continues to affect the global economy, as recent bank writedowns reveal. In the past month, banks such as Citigroup, Merrill Lynch, UBS, and most recently, Credit Suisse and Barclay’s, have posted significant writedowns due, in part, to sub-prime mortgage market exposures.

These writedowns have resulted in 2007 yearly and/or 4th quarter losses for those banks that did not have sufficient profits in other exposures. For example, UBS AG reported over $18 billion in losses for 2007 and may report an equal amount in 2008. British bank Barclays reported £1.6 billion in credit-related losses, warning that the losses will continue to accumulate for at least 6 months.

Credit Suisse has been able to retain its profits, but despite an initial statement that it was unaffected by the sub-prime mortgage crisis, CS nevertheless reported substantial ($1.88 billion) writedowns related to asset-backed securities such as CDO’s.

As a result of sub-prime related losses worldwide, global banks that the U.S. depends upon for financing may be unable or unwilling to fulfill those needs. For example, banks in China and Japan hold almost 50% of the U.S. public debt – money that is used to maintain the government and its services. According to recent reports, banks in China may take tremendous writedowns (and possible losses) due to their large exposure to sub-prime mortgage securities. Their willingness to continue offering credit to public and private sectors of the U.S. may decline if the impact of these writedowns is strong.

If less foreign credit is available to finance the United States, the alternative is monetizing the debt, via purchase of government bonds by the Federal Reserve. This has the effect of increasing the money supply, lowering the value of the dollar, lowering interest rates, and increasing inflation. The rate of inflation for January 2008 was 4.28%, more than twice the rate of the previous January. Likewise, the value of the dollar has already declined with regard to many major currencies. The sub-prime mortgage crisis may indirectly worsen these situations.

What does this mean for consumers and lenders? First, increasing inflation will tend to raise housing costs, which may result in a declining market for home loans. Second, the expanded money supply means more credit will be available, and if fewer people are looking for loans, competition among lenders will increase. Third, lower interest rates mean less income for the lender.

Institutions may be tempted to continue the same practices which led to this crisis – giving loans to those with poor credit, or encouraging home buyers to finance their homes at higher interest rates than those for which they qualify, in order that the institution will make a higher profit. However, the continuing aftershocks from the crisis that was caused by these and other poor lending policies make it clear that these practices will lead to a vicious cycle that could destroy the economies of both the U.S. and global economies, resulting in global economic depression as a worst case scenario.

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