How did the US sub-prime lenders get into trouble?

March 12th, 2007

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As you would have known by now, there has been a lot of news lately in the financial press regarding the crisis that is hitting the US sub-prime lenders. For example, New Century Financial, the biggest US sub-prime lender is facing threats of bankruptcy (New Century plunges on bankruptcy woes). Even HSBC, the third largest bank in the world, had to issue a warning that ?its bad-debt charges will be 20% higher than forecast.? (Sub-prime gloom picks up after HSBC warning).

How did the sub-prime lenders get into trouble in the first place?

First, for those who are uninitiated, we will go through a brief introduction on what sub-prime lending is all about. Basically, sub-prime lenders are those in the business of offering mortgage loans to those who should not be getting them in the first place. Their clients are the ones whom the traditional banks generally shun?those with low income, blemished credit records and non-existent credit history. Also, many of such borrowers tend to be more financially illiterate as shown by the fact that many of them got lured into loans that they cannot afford.

You may ask yourself this obvious question: how can offering loans to the most unreliable borrowers be good business? This is indeed a very good question. Questions such as this had been asked a few years ago when such business were still ?good? business (see Subprime loan market grows despite troubles). Perhaps this type of business requires a great deal of sophistication and complex mathematics in order to be profitable? Apparently, this was what HSBC believed, to their regret?their faith in their superior ability in mathematics was eventually unfounded.

It was a ?good? business as long as the floodgates of liquidity is wide open and bringing about a high tide of rising house prices (see The Bubble Economy). What if the borrowers default on their loans? Never mind, just repossess the houses and sell them into the market to the next fools who are most willing to pay higher prices for these houses. But what if the house prices are stagnating or heaven forbid, falling? Oops! But as long as the borrowers still have the income to repay the loans, all will be well right? But wait, what if the teaser interest rates that lured the borrowers into the loan are what they can afford and they cannot meet the repayment of the normalised interest rates? Oops! Oops!

So, it does not take a genius to see that sub-prime lending is a fundamentally bad business. That is why the traditional banks would never want to touch the sub-prime borrowers in the first place.