Members of the Cayman Islands Bankers’ Association and invited guests received a gloomy outlook on the US subprime mortgage crisis last week.
The social event, which was held at the Marriott Beach Resort, marked a new approach for CIBA, said its President Conor O’Dea.
‘The idea of the social is to get bankers together to discuss issues affecting the industry,’ he said.
As a way of mixing business with pleasure, CIBA had Stuart Sybersma of Deloitte Cayman Islands and Phoebe Moreo of Deloitte New York give a presentation of the origins of the much-reported American subprime mortgage market meltdown, which has led to loan foreclosures and a housing slump at levels not seen since the Great Depression of the 20th Century.
Subprime mortgages refer to loans given to high-risk borrowers who often don’t have the earnings, credit history or income potential of prime risk borrowers.
Because housing prices were rising at phenomenal rates – housing prices doubled in the US between 1996 and 2006 Mrs. Moreo said – even subprime borrowers were earning equity on homes through appreciation.
The subprime mortgages were then pooled into collateralized debt obligations, a form of asset-backed security, which was sold to investors in tranches that ranged in credit risk. These risks were established by credit rating agencies. Even though they were all collateralized with subprime loans, some of the securities received AAA investment ratings.
The CDOs were sold globally, with about one third going to the US, one third to Europe and one third to Asia.
Many of the original loans were sold with adjustable rate mortgages, often with low teaser interest rates to entice borrowers. However, when the teaser rates reset, many of the borrowers could no longer afford to make their payments and foreclosures increased dramatically.
This ultimately affected banks and investment community as the CDOs failed to deliver the cash flows projected. Even the AAA-rated securities were hit, leading to billions of dollars of losses by major global firms.
High-profile company losses piled up with write-downs by Citigroup of $40.7 billion; by UBS of $38 billion; by Merrill Lynch of $31 billion; and by Morgan Stanley of $12.6 billion. All together about $350 billion of losses and write downs have been disclosed so far.
Mrs. Moreo said that figure has a way to go yet before it included all the subprime losses.
The International Monetary Fund has estimated losses and write downs will eventually hit $945 billion.
‘The real crisis is ahead,’ Mrs. Moreo said.
Mr. Sybersma agreed.
‘There’s a lot of pain and bad paper out their in the world economy.’
A large amount of adjustable rate mortgages are scheduled to reset this year, many of them from last month, which will put pressure on subprime borrowers to make higher mortgage payments.
Mrs. Moreo said it is estimated that one out of every eight homeowners will end up in foreclosure in the next five years, with 2008 being the peak year.
Additionally, with housing being the traditional driver of its economy, the US could face a protracted economic slowdown.
The US Government is takings several steps – such as lowering interest rates, giving a tax rebate to encourage consumer spending and offering fixed rates loans to holders of adjustable rate mortgages to prevent foreclosures – but it is unknown if the reaction will be enough to ward off a US recession.
One positive from Cayman’s perspective in the sub-prime crisis is in the hedge fund industry.
‘For the most part, the hedge fund industry has fared fairly well,’ Mrs. Moreo said, noting that only about two per cent of hedge funds have failed because of the subprime crisis.
Mrs. Moreo outlined several things that will happen as a result of the subprime meltdown, including stricter regulations on a global level and wider diversification by investors.
‘I think we’re in for some very challenging times and some good opportunities,’ she said.