The Subprime Fallout-Local Difficulty Or Global Crisis? The Implications For English Litigators

Introduction

A credit crunch is the term economists use to describe a financial environment where investment capital is in short supply. It is a recessionary period in a debt-based monetary system where growth in debt money has slowed which subsequently leads to a drying-up of liquidity in an economy.1 A credit crunch is also known as a 'liquidity crisis' or a 'credit squeeze', where the banks will not or cannot lend and where investors cannot or will not buy debt. When it suddenly becomes very difficult to borrow money, this can have serious implications for an economy, both for private individuals and business. A credit crunch is often caused by poor and reckless lending, which results in losses for lending institutions and investors in that debt.

Global economic growth has been driven by access to cheap money; the ability to borrow at low rates. Recently the cost of borrowing, for both individuals and banks, has risen as institutions have become wary of lending money; at the same time banks are trying to conserve liquidity which has forced up borrowing costs. Problems in the global economy started when homeowners in the US, in the subprime market, began to default on their mortgages as repayments increased. This provided the trigger for the credit crunch which today threatens the macroeconomy.

Subprime is technically the name given to a loan to a borrower who has a low credit score: that is, a bad credit history. The interest rate for these loans is typically 2 to 5 per cent higher than for a prime loan.

The other sort of lending which has had an effect on the credit squeeze is 'Alt A' mortgage lending. 'Alt A' loans, also known as 'liar loans' require no documentation form the borrower who can self-certify their income. This type of lending was more limited in extent and the typical loans were provided to real estate speculators.

These mortgage loans, including subprime and 'Alt A' content, were then re-packaged in collateralised mortgage obligations. These collateralised obligations are like bonds and they are secured by the underlying properties and backed by payments on the underlying loans. These collateralised mortgage or debt obligations (CDOs) were then rated by the rating agencies and sold to other institutional investors. The original mortgage lenders retained no liability in respect of the loans and the sale of the collateralised obligations provided the liquidity to fund further loans. Inevitably, the original lenders appear to have relaxed their underwriting criteria, the number of such loans went up from about $200 billion in 2000 to $600 billion in 2006. This represents an increase from 8% to 25% of all mortgage loans. 2

Not all subprime loans were actually sold to subprime borrowers. In fact, it has been calculated that some 61% of subprime lending would have qualified for prime loans. There is therefore a potential exposure on the part of mortgage brokers to claims for misselling.

The mortgage loans were themselves divided into a number of categories: traditional interest and principal repayment; interest only loans: where interest only is repayable for the first 3 to 5 years of the loan; Adjustable Rate Mortgages ('ARMs'); Option ARMs: where the borrower has an option on how much interest and principal he wants to repay at any time and if less than the normal interest payment is made then it is added to the principal amount of the loan leading to what is colloquially known as 'negative amortization' in the US.

In 2005, the adjustable loans represented about 51% of total lending. 70% of the adjustable rates were adjusted in 2007 and 78% will be adjusted in 20083. These adjustments have resulted in a payment shock for investors after the initial 'teaser periods'.Some borrowers have found it impossible to re-finance as underwriting guidelines have been tightened or the value of property has declined.

Another problem for the lenders, apart from non-payment of loans, is that when mortgage debts were collateralized, it seems that the security of the underlying properties was not properly transferred at the same time. This fact came to light during the recent decision against Deutsche Bank in Ohio, when the Bank tried as trustee of collateralised mortgage obligations to recover debts from borrowers by enforcing charges over their properties. The borrowers put them to proof that the mortgage loans had been properly transferred. All that Deutsche Bank was able to show was a document showing intent to convey the rights in the mortgages, not the transfer itself, and Deutsche Bank lost its case. 4

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