There has been myriad commentary in recent months on the problems associated with the sub-prime mortgage issue that reared its ugly head in 2007, and the ensuing credit crisis and falling equity markets that we have witnessed. In view of this, we have attempted to shed some light on the issue by providing a simple explanation as to how the sub-prime mortgage problems in the US started.

Between 2000 and 2006, the borrowing capacity of the typical US home buyer more than tripled. This was fuelled by gradually increasing income, lenders becoming increasingly more complacent in allowing higher debt to income ratios, falling interest rates, the adoption of interest only mortgages, honeymoon (teaser) rate loans and zero collateral loans (no money down). This was simply a trend towards easier lending that resulted in increased liquidity and, of course, pushed housing prices (and other assets) higher.

The decline in mortgage lending standards came about due to one, simple factor: structural incentivisation. What that means is that those responsible for the writing of a loan were remunerated to write the loan and were not incentivised to write it responsibly… i.e. those that lent the money were not responsible for the money being repaid and therefore lent irresponsibly. Loan to value rates (leverage) increased from 79% (2001) to 89% (2006), the number of loans that were lent on a no-money down basis went from 3% to 33%, limited document (low doc in Australia) loans went from 27% to 44% and finally, loans that were lent on the basis of no money down and low doc went from 1% to 15%. Clearly, there were many people borrowing money who had no sound track record of savings or income.

In 1994, less than 1% of loans written were classified as sub-prime. In 2006, it rose to 13.6%. This explosion of liquidity led to an unprecedented rise in property prices from 2000 to 2006, significantly above the long term growth trend.

Why did this happen? Wall Street discovered the enormous demand for (and profitability of) collateralised debt obligation securities. These were basically packaged up loans that paid regular income to the holders of these securities. Simply increase the loan to value ratios, provide ultra low teaser rates to un-creditworthy borrowers and don't bother to verify their income and assets. Wall Street didn't care, as long as property prices kept going up and the properties could always be resold.

The problem was that borrowers started to default and supply started to increase as demand stopped and prices started to slump. After all, every boom busts. House prices, as reflected by the S&P/Case-Shiller index, which rose between 5%-15% every year between 1998 and 2006, fell around 10% at the end of 2007.

Foreclosures rose 57% and repossessions rose 90% year on year in January. 30% of subprime loans written in 2005 and 2006 are underwater (negative equity). In the last quarter of 2007, 5.82% of all mortgages were delinquent (30 days overdue), the highest level in 23 years (0.83% were in foreclosure, an all time high). Of all adjustable rate sub-prime mortgages, 20.02% were delinquent and 5.82% were in foreclosure.

Home sales have plummeted by around 30% year on year and The National Association of Realtors claim that existing homes inventory has skyrocketed from between 4-5 months demand to 10-11months. The real estate agents get badly hurt in these downturns.

While the actual credit problems evolved from sub-prime, they have been so widespread and unpredictable (as to who has been affected) that lenders have stopped lending and this has created further problems not directly related to sub-prime.

There remains about $US440bn worth of home loans in the market that are supposed to be reset (at higher rates) this year. Most borrowers are expected to either refinance or sell their property before the reset period. It is not out of the question for the government to buy these loans in order to provide some relief to borrowers, but time will tell. Either way, home owners are looking at a long period of indebtedness and lower home values, which will impact their ability (and confidence) to spend on other things for some time.

In conclusion, the great boom-bust of the new century will pass. It will take time as there is no quick fix for the millions of Americans left with deflated property values and the overhang of supply should keep a lid on US residential property for some time.

In Australia, we do not have the extremes that the US had in terms of low doc and inappropriate lending (but we do have much higher rates) and we have our friend China up the road buying all the raw commodities it can get its hands on. This has led to massive increases in our country's exports, mining profits and tax paid.

However, it seems likely that Australia will be affected due to the significant slowing in the US and the rest of the western world. Our high level of consumer debt and high interest rates appear a toxic mix for domestic growth. Even if our miners continue to generate strong revenues for our country, it seems unavoidable that our economy will slow and many businesses and sectors will be impacted. It will be those with high debt and poor security that get hurt the most.

For those cashed up or sensibly geared in secure positions, the next 1-2 years may represent the greatest investment opportunity of a lifetime, but just don't ask us to ring the bell at the bottom."

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