What is meant by subprime mortgage crisis? Does it effect our Malaysia's economy?

Question:

What is meant by subprime mortgage crisis? Does it effect our Malaysia's economy?

What is meant by subprime mortgage crisis? Describe the causes and risks of subprime mortgage crisis to the various markets in your country. Which sectors of the economy were more severely affected? Which sectors were relatively unscathed?

· apply basic financial economic theory to explaining the workings of the domestic   and international financial systems

· demonstrate a working knowledge of the institutional framework for financing economic activity

· demonstrate an understanding of the operation of domestic money and capital markets and of their linkages with global financial markets

Analyse the effects of changes in the private financial system on economic activity.

Introduction

Sub prime mortgage crisis has made the total number of job losses in United States for year to date is more than 230,000.It has risen to more than five percent compare to year 2006. (AEP, 2008) This has happen because of credit crisis which started in the sub prime mortgage market. The purpose of this essay is to discuss the meaning of sub prime mortgage crisis and to analyze the causes and the risk to Malaysia’s various markets. In particular the focus is to the affected industry .Sub prime mortgage started in United States and had caused a deep slump in global trade including Malaysia.(Insap,2007) Finally a discussion on the mitigation step taken and their effectiveness to minimize the impact are presented in the essay.

The Definition of Sub prime Mortgage crisis

The commencement of the sub prime crisis can be map out back to the time when banks luring cheap short-term credit for sub prime borrowers a few years ago. (Aseambankers, 2008) The low interest rate environment has spurred increases in mortgage financing and substantial increases in house prices. (Crouhy et all.., 2008) The huge demand for these loans triggered the miscalculation of risk and made it possible for any consumer to buy a house. (Aseambankers, 2008) Individuals were speculating on the booming property market by buying multiple properties. The US federal Reserve in turn had kept interest rates low, thus giving consumer high reasonable price to own properties.( Aseambankers,2008) The lender primary consideration for loan quality was the ability to sell in the secondary market.(Gwinner & Sanders, 2008) A sub prime mortgage is to establish a loan to unqualified borrower. Often these borrowers have less or even no credit history. Sub prime mortgages often offer interest- only loans. Borrowers are to repay the interest towards the beginning of the loan tenure. (Amadeo, 2010)

Causes and risk of sub prime mortgage crisis. 

Sub prime mortgage market fall because of many reason involved. Researcher had proved that the securitizers were to some extent aware of it. (Demyanyk & Otto, 2008) August 2007, the sub prime mortgage problems started to surface in the financial market. The mortgage lenders were unable to repay their debt since the housing price bubble busted and their mortgage become larger than the value of their houses. (Insap, 2007) The fall of sub prime mortgage happens because of the unsustainable growth. (Demyanyk & Otto, 2008). Once the loan had been granted to poor credit histories borrower they are more likely to default. (Amadeo, 2010) Since the process of granting a loan is easy. This has driven the property prices increases in some areas given that the supply is the same. Banks and investors act procyclically, extending credit more aggressively and competing for market share as collateral prices rise.(Gwinner & Sanders, 2008)as oppose to the declining income growth in these sub primes zip codes and  their neighborhood. (Atif & Sufi, 2008)

In the first part of decade the interest rate were relatively low. Investor is looking for a better yield income. Subprime mortgage offer higher yield than standard mortgages and have been in demand for securitization.(Crouhy et all., 2008) Once the security back by mortgage has been issued, it may be traded from one investor to another.(Gallagher & Andrew, 2000) Generally the seller of this security have no other involvement in the process (meaning that investors rely purely on the mortgages as security and have no resource to the lender should borrower default).( Hunt & Terry , 2008) Secondary market transactions occurs thousand of times as investors trade securities among themselves. (Gallagher & Andrew, 2000)

Between 2001 and 2006, between 60 and 80 percent of sub prime loans were bundled into mortgage- backed securities and sold to investors in capital markets (Gwinner & Sanders, 2008) The theory of risk –return trade off is playing their part here, bank wouldn’t take additional risk unless they expect to be compensated with additional return. This axiom established the fundamental risk- return trade-off that govern the financial market (Keown et all, 1998)

Bank repackaged mortgages with different risk profiles and included a slice of sub prime loans to enhance the yield. (Aseambankers, 2008) This in contrast with the bank lending model followed in most emerging markets, where banks originate and holds the loans in their portfolios fund them with deposits and retain the risk of default. (Gwinner & Sanders, 2008)

Effectively, the banks were giving loans to people who could not afford the houses and selling the loans via all sorts of methods to other banks. The problem was those low rates were not really profitable, especially when the Fed was hiking up the lenders’ cost of funds at the same time. In order to boost profits, the sub prime lenders started raising their lending rates. When the interest rates were abruptly raised, monthly housing payments were raised substantially. This made it difficult for homeowners to pay their mortgages, they in turn started selling their homes. The subsequent effect was an oversupply of houses, which led property prices to drop. Speculators were losing money instead of making money. As a result, homeowners started defaulting and declaring bankruptcy. Banks that are provided the financial backing for these loans were affected when the borrowers started defaulting, and the collateralized debt obligations and mortgage-backed -securities could not be resold on the market. As a result, banks could not repurchase them as investment anymore and were forced to sell the papers before prices deteriorated further. In addition, banks refused to buy each other’s short term debt resulting in a vicious cycle of forced selling. (Aseambankers, 2008)

The cause and risk of sub prime mortgage crisis to the various market in Malaysia.

Primarily due to lesson learned in 1997 crisis, most Asian countries also have much better financial regulatory regimes in place than they did a decade ago. Their commercial banks have better corporate governance and better internal risk management and their corporate sectors have much lower leverage. Direct exposure to both sub-prime and derivatives overseas is limited. (APCO, 2008) Broadly speaking, there has been no sub prime mortgage lending in emerging markets. Instead, mortgage lending is typically made on conservative terms to middle and upper income households employed in formal sector, (Gwinner & Sanders, 2008) and their backwardness has prevented Asian lenders from moving into complex and sophisticated products.

Malaysia financial system has not been affected by the crisis and our economy is still resilient. (Benjamin, 2009) Malaysia Second Finance Minister ensures that Malaysia has sufficient tools and strengths within its economy to withstand a slowdown in the global economy. (Insap, 2007) Despite of the comment in the news that our financial market is not affected by sub prime mortgage crisis, Malaysia still feels the heat on the incident. The deep slump in world trade and commodity prices had a much bigger impact on Malaysia than expected.(Asian Development Bank, 2009)This is evidenced by our Kuala Lumpur Composite Index falling to a five month low of around 1,141 point on 18 August 2007 following from the Dow Jones fall. The credit squeeze caused by the sub prime mortgage crisis triggered global sell-off equities. The spooked investor in our own local bond market, setting of a selling frenzy, which pushed the yield curve higher as will be shown next. (Wee, 2007)

Malaysia’s bond market, which has been existence since 1960s, saw numerous institution developments during the late 1980s. Important changes include the establishment of national mortgage corporation Cagamas in 1986 to develop the secondary market in our capital market via securitization of housing loans. (MIF, 2008) In principal Malaysia market securitization has not reach the level as what is happening in United States. However the losses suffer by Malaysia financial market will be indirect losses which may come from their investment in purchasing bonds or equities in the infected western financial institution. (James et al.,2008)It is true that the sub prime crisis and the likely US recession have taken a toll on Malaysia bond market and the  Islamic Sukuk too, despite our financial market especially the bond market is one of the most developed in the region.(Benjamin,2009)

The second industries that is badly affected by the US sub prime crisis is the export dependent manufacturing sector, was particularly vulnerable to the global crisis. (Nambiar, 2009) Malaysia’s export are closely tied to the US economy.(Insap, 2007) It has been observed, that the current crisis has had an impact on Malaysia through the contraction of trade and FDI inflows (James et al.,2008)These declined have resulted in labor market shocks which have led to retrenchments. (Nambiar, 2009)

The banking sector lies at the very core of Asian financial systems, and the banking sector has been largely unscathed. (Asian Development Bank, 2009)  The adverse impact of global financial crisis on Malaysia has been limited and transmitted through indirect, peripheral channels.(James et al., 2008) Various financial indicators and banking sector data support the contention that Asia’s financial system were well prepared for the crisis. Nonetheless, stock prices in Asia were closely linked to global markets and suffered badly in 2008. Although Malaysia has not been directly impact by the sub prime mortgage crisis, steps are taken to cushion the related industry. Next, the reader will be taken into the step taken by the Malaysia government to minimize the impact of sub prime mortgage crisis.

Steps taken by the government and central bank to mitigate the impact of sub prime crisis

The Malaysian economy is expected to benefit from ongoing measures globally to stabilize economic conditions through fiscal measures and loose monetary policy, as growth is projected to rebound into positive territory in 2010. (Jagdev et all…, 2009) Malaysia government rolled out two fiscal stimulus package, and interest rate were lowered to spur the economy, an easing of monetary policy, and a relaxation of local equity requirement for some foreign investor are among the incentive offered. (Asian Development Bank, 2009)

The first fiscal stimulus package includes seven billion spending announced in November 2008 and the Ringgit Malaysia sixty billion spending under the Mini budget announced in March. Malaysia Prime Minister, Datuk Seri Najib Tun Razak has committed an extra Ringgit Malaysia one billion per month until the end of 2010 to pump – prime the domestic economy. The move is to lend additional crutch to the local economy to find growth. (Kok, 2009)

In response to the deteriorating domestic economy and slowing inflation, Bank Negara Malaysia, the central bank reduced its policy interest rate in steps from 3.5% at the beginning of November 2009 to 2.0% in February 2009, and its reserve ratio for commercial banks to a record low of 1% from 3.5% in November 2008. The second is a trade weighted depreciation of the currency has further relaxed financial conditions. (Asian Development Bank, 2009)

Other than the financial stimulus and the interest reduction, the government is also activating back the Corporate Debt Restructuring Committee was establishes during the 1997/98 Asian Financial crisis to assist companies with debt problems. CDRC (Jagdev et all., 2009)

In other changes, the Government reduced the minimum stake to be reserved for Bumiputra investors in initial public offerings to 12.5% from 30% and eased rules on foreign investors buying stakes in Malaysian companies and property. (Asian Development Bank, 2009)

Evaluation of effectiveness of steps taken by the government and Malaysia Central Bank

The year 2010 is a recovery year. If recovery is strong, we may find ourselves achieving even higher growth with the additional government spending. (Kok, 2009) Now we can see that there are sign of improvement in the global economy. (Andrew, 2010)Malaysia economy contracted by 5.1% in the first half of 2009, more sharply than expected. On the production side, only services grew, while manufacturing output, which is dominated by export–oriented industries, contracted sharply and agricultural production declined. (Asian Development Bank, 2009) Whilst on the stock market the benchmark index FTSE Bursa Malaysia KLCI, was on rally last seen during the heydays of the Malaysian economy in the early 1990s. Stock on Bursa Malaysia rallied uninterrupted for 13 straight days as investor interest returned for a number of reasons. The sub-prime mortgage crisis tragedy offered low yields on stocks, real estate, bonds (Andrew, 2009) Hence we have not seen the end of the crisis. (Andrew, 2010) It was early to conclude that the economy is recovering or that the step taken by the government is effective. The better outlook is underpinned by the fiscal stimulus and the expected recovery in world trade and commodity prices. (Asian Development Bank, 2009)

So far global growth has been due to fiscal pump primp and historically low interest rate. The steps taken by Malaysia’s government has seen the situation whereby the financial markets are having a huge profit after the governments have rescued the financial institutions by massive guarantees and zero interest rate policy. (Andrew, 2009) One thing that could stop the recovery in its track is a premature exit from stimulus spending. (Kook, 2009)

While on the recovery side, CDRC (Corporate Debt Restructuring Committee) was reactivated as a pre-emptive measure to help distressed companies during the current economic downturn. This action to reactivate the CDRC may not be as efficient as the small number indicates the corporate position now than during the Asian financial crisis. (Jagdev et all..,2009)

Conclusion

In conclusion we can say that greed, fraud, problem resulting in lack underwriting standards, incentive issues, failure to identify a changing environment, poor risk management by financial institution, lack of transparency, the limitation of extant valuation models and the failure of regulators to understand the implications of the changing environment for the financial system is the major reason for the fall of the sub prime mortgage. Helping people to get a house to is a noble job, but without proper mitigation to the risk will make the economy suffer, when the bubble bust. In summary it is clear that U.S. sub prime crisis has an effect to Malaysia, as an emerging market. This essay has satisfied the purpose of defining and identifying the root of sub prime crisis and the affect of it to Malaysia economy.

List of references:

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