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John Quiggin

Sub-prime no threat, so far

John Quiggin Australian Financial Review

2 August 2007

The turmoil originating in US mortgage markets has, so far, had mainly indirect effects on Australia. A couple of hedge funds with exposure to the subprime market ran into difficulties last week. This week, there were big losses reported by two Macquarie funds with investments in senior secured US corporate loans.

As a result, the stock market has had some bad days, culminating in yesterday’s 3 per cent slump. The Australian dollar has fallen back a bit, not helped by yesterday’s trade statistics.

Quite possibly, there will be nothing more to it than that. Given reasonably strong macroeconomic conditions, financial markets are in a relatively good position to handle a panic originating with a particular class of financial instruments.

Still, there are some more worrying aspects to the developments of the last week. Until then, problems had been confined to the ‘sub-prime’ sector of the US markets, catering to borrowers with poor credit, many of whom would have been unable to get access to a mortgage in the past. While default rates for subprime borrowers soared, the rest of the market seemed unaffected. The most recent available statistics showed that default rates for prime and near-prime borrowers were well below the levels of the mild recession of 2001-02.

The news that triggered the current turbulence was an announcement by Countrywide Financial, the largest mortgage lender in the US, that borrowers with good credit records were defaulting on payments at a higher rate. The Countrywide announcement referred mainly to home equity loans. Other lenders have reported difficulties with ‘Alt-A’ loans, which are low-documentation loans favored by investors hoping for quick capital gains.

Problems spread rapidly to collateralised debt obligations, derived ultimately from mortgages. These securities are packaged in such a way that some investors are supposed to absorb the risk of default, leaving the rest with a high level of security, so high that a large proportion of CDOs have been rated AAA by agencies such as Standard & Poors, even where the underlying mortgages were subprime. In the last week, there has been a flurry of downgrades, raising questions about the validity of the initial ratings.

From the mortgage markets, problems have spread to debt markets in general, and particularly the market for debt used to finance company takeovers and leveraged buyouts. A number of deals have been abandoned or modified.

The effects on Australia of any economic disruption in the US remain to be seen. But we should be equally concerned that Australia is vulnerable to homegrown problems of the same kind.

Until recently, there was no reason to worry. It appeared that the Australian market had no real equivalent to the subprime market in the US. But many households have borrowed heavily on home equity loans, and plenty of investors who’ve followed a low-document route similar to the Alt-A class in the US.

So far, and despite statistics showing that many households are paying out a large proportion of their incomes in mortgage repayments, there is no indication of any real problem here. But then, unlike the United States, Australia has not experienced any broad decline in housing prices. With the exception of some parts of Sydney, prices have remained high or even grown further.

A substantial decline in house prices would certainly produce plenty of distress for households. Whether banks or other lenders have prepared adequately for such an event remains to be seen. They have had plenty of warnings, and the Australian Prudential Regulatory Authority remains cautiously confident that the risks are being managed.

There are deeper reasons for concern, though. The boom in house prices has been self-sustaining, and reflects the underlying logic of leverage. If interest rates are low, and asset prices are increasing, anyone can make money and does. As the saying has it ‘genius is a rising market’. Once the market starts falling, it usually turns out that lots of bad decisions have been made.

Australians have embraced the logic of leverage as individual property buyers. We have also embraced it as a nation. Current account deficits that would once have been viewed with alarm are now regarded with benign indifference.

The underlying assumption is that asset markets are now so flexible and sophisticated that there is no need to worry about Australia’s aggregate position. If individuals borrowers and lenders have made bad deals that is their problem. Contagious panics, it is assumed are a thing of the past.

More than likely, the current problems will pass smoothly. But as individuals, and as a nation, we would be well advised to check our exposure to risk.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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