US Sub-Prime Mortgage Crisis

In June this year Federal Reserve chairman Ben Bernanke warned that the crisis in the US sub-prime lending market could cost up to $ 100 billion. Company financial reports already reveal losses up to $ 50 billion.

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In June this year Federal Reserve chairman Ben Bernanke warned that the crisis in the US sub-prime lending market could cost up to $ 100 billion. Company financial reports already reveal losses up to $ 50 billion. Some predict that the scale of the losses that will hit Wall Street banks could approach half a trillion dollars leading to a credit squeeze that will dampen economic growth for years to come. The US sub-prime crisis is leading to a wave of repossessions across the US that is having a devastating effect on the US housing market, and is likely to lead to the halving of the US economic growth rate in the next six months. There have already been 1.7 million foreclosure (ceasing and taking re-possession) proceedings in the US in the first eight months of 2007, and up to 2 million families are expected to lose their homes over the next two years, according to estimates by the US Congress’s Joint Economic Committee. The Fed along with European Central Banks is pumping billions of dollars to arrest the credit squeeze and lower interest rates. There is serious debate on the possibility of a full blown recession in America in 2008 leading to a global economic downslide.
Traditionally, American banks had financed their mortgage lending (housing loans) through the deposits they receive from their customers. This had limited the amount of mortgage lending they could do. However, since a few years, banks moved to a new model in which they would sell the mortgages to the bond markets. This has made it much easier to fund additional borrowing. But it also led to abuses as banks did not check carefully the mortgages they issued for the simple reason that it was not their own money but of the shareholders who had invested in those bonds.
In the past five years, the private sector expanded its role in the mortgage bond market, which had previously been dominated by government-sponsored agencies like Freddie Mac. These housing finance companies specialised in new types of mortgages, such as sub-prime lending to borrowers with poor credit histories and weak documentation of income, who were disqualified by the “prime” lenders like Freddie Mac. Banks did booming business as they earned a fee for each mortgage they sold on. They urged mortgage brokers to sell more and more of these mortgages. Now the mortgage bond market is worth $6 trillion, and is the largest single part of the whole $27 trillion US bond market, bigger even than Treasury bonds. By then, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time in the “hot” housing markets of Southern California, Arizona, Nevada, and the suburbs of Washington, DC and New York City.
The number of people who defaulted on these sub-prime housing loans (mortgages) was quite high. Most of them were lured in taking those mortgages by hard selling a very low initial interest rate and monthly EMI (Equated Monthly Instalment) and not informing them that payments were fixed for only two years, and would become variable and much higher after that. Consequently, the number of repossessions is likely to spiral as many of these loans will switch to higher rates of interest in the next two years. And it is likely that as many as two million families will be evicted from their homes as their cases make their way through the courts.
The wave of repossessions had a dramatic effect on house prices, reversing the housing boom of the last few years and causing the first national decline in house prices since the 1930s. There was a glut of four million unsold homes depressing prices, as builders were forced to lower prices of housing units to get rid of their unsold properties. And house prices, which are currently declining at an annual rate of 4.5%, are expected to fall by at least 10% by next year – and more in areas like California and Florida which had the biggest boom. The property crash is also affecting the broader economy, with the building industry expected to cut its output by half, with the loss of between one and two million jobs. Many smaller builders will go out of business, and the larger firms are all suffering huge losses. The building industry makes up 15% of the US economy and a slowdown in the property market will also hits many other industries, for instance makers of durable goods, such as washing machines, and household furniture. With banks and lenders now becoming careful, credit availability became difficult. The housing loan market was particularly badly affected, with individuals finding it very difficult to get non-traditional mortgages. The banks have been forced to do this because of the drying up of the wholesale bond markets and by the effect of the crisis on their own balance sheets.
Islam prohibits lending on interest. The main difference between Islamic and conventional housing finance is the former is equity based while the latter is debt based. In an Islamic mortgage both the bank and the client share the ownership of the property and therefore share the risk of the equity ownership. In conventional banking the client owns the equity and the bank loan to the client is secured on the value of the property. The Islamic principles of sharing risks and rewards, and participating in the wealth creation activities via equity rather than debt has a solution that eliminates debt in its existing interest based form while continuing to promote entrepreneurship and creativity in the economic cycle. Thus Islam strictly rejects the financial model of selling housing loans in the stock market as bonds and using those funds to give house loans on interest. Responsible lending and affordable housing marks the Islamic Welfare State. No other way to save the American Dream.