The US credit squeeze and its global impact.

6-12-2008

The credit squeeze in the USA is on the verge of pulling the American economy down into recession and in a bid to avoid this outcome, the Bush Administration is making noises about stepping in to protect mortgage borrowers in the USA from a spike in interest rates. But, you've got to ask yourself, why is this necessary? And what are the long term problems here?

a large number of mortgages in the USA are taken out with a short fixed term that has a low interest rate, after which the rate becomes variable. The problem this creates is that only the initial phase of the mortgage can be afforded by the consumer - when the low interest period ends, repayments go up and affordability of the loan becomes a problem. That this problem has arisen should be sending a very big signal to the finance sector in the USA: this model is flawed and is incredibly dangerous.

So the President stepping in here and protecting consumers from an upswing in interest rate on their mortgage that they won't be able to service, is actually an act of protecting a flawed business model employed by the financial institutions. The action here just pushes the problem out to the future for someone else to deal with. Freezing the current interest level for certain buyers, for a few years does nothing to increase the ability of the consumer to actually service the loan. But with his tax cuts and other irresponsible fiscal policies, this move should come as no surprise.

There's a double whammy here for consumers: their financial institution has given them a loan which they can service during the honeymoon period but cannot after that ends. Amongst the other outcomes, this will negatively impact consumers' credit rating, making future loans more expensive as the interest rate for loans is indexed on credit rating (but that's a completely seperate problem.)

Criticism of Bush's plan isn't limited to folks like myself. Others, such as Pimco's portfolio manager are also criticising the move. An indication of the view that this is a vote buying exercise is Senator Hillary Clinton's jumping on this bandwagon and saying Bush isn't doing enough. If anything it should be comforting that both political parties (and their leaders) seem to be no wiser than the other.

Has the US credit problem impacted Australia? Yes! One of the cheaper non-bank providers of home loans, RAMS, has this year been bought out by a bank as they found themselves in an unfavourable position: they had been buying cheap credit in the USA and with the exchange rate moving against them, their costs went up. Rather than increase the cost of their loans (by increasing the mortgage repayment %) to consumers, they sunk the company.

Update (7/12/2008)

Today I found an excellent article in The Age explaining the situation and how the subprime American loans are affecting people in Australia: When California Quakes, Beaumaris Shudders. I'd recommend this article to everyone who has a home loan today as it walks through in almost layman friendly terms how the problem started and how it is affecting everyone today.

The picture now being painted of this crisis in the USA is becoming progressively worse, with some referring to it as hurricane katrina fro the financial market. What picture does this paint for 2008? Hard to tell. The aforementioned article is predicting a significant slide on Wall Street. But one thing is for sure: the financial markets do not like this move by the current president of the USA.

Comments:

i do agree with your statement that the sub-prime will be affecting Australians. However i feel that the world is currently feeling the effects of the sub-prime crisis, hong kong markets are having a tough time dealing with the huge write-offs and so is Japan which is a main partner of the US. The most important issue here as i do agree with you is how to move forward with a new model replacing the flawed business model of dishing out loans to people who can't service the full tenure of the loan. Sometime the US goes for a quick fix to stimulate consumer spending without taking into consideration the long term impacts, which we are facing now. They should have tighter loan conditions but this will contract the property market - a chicken and egg situation. Thanks for the great article and comment :)

Posted by idot60 on December 07, 2007 at 01:20 PM PST #

I guess the difference is that brokers are motivated by large bonuses, wheras bake employees are usually on a simple wage.

Posted by Australian home loans on December 03, 2008 at 05:03 PM PST #

From the consumers perspective though it is now even more crucial to save on home loans as much as possible.

Posted by Ziggy Bid Mortgages on February 03, 2009 at 09:11 AM PST #

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