GRADUATE ACCOUNTING AND COMMERCE CENTRE

DIVISION OF ECONOMIC AND FINANCIAL STUDIES

ACCG837 CAPITAL MARKETS

Sub-prime Crisis in Australia?

A Deeper Insight

October 30, 2007

Christopher J. Kightley

Moritz Meidert

Artur Penkala

Table of contents

I.

Table of contents

1

II.

Relevance of sub-prime mortgage market

2

a. Recent problems in the US-market

2

b. Reaction of the stock markets in Australia

2

III.

Structure of the mortgage markets

2

a. Loan policy of Australian banks and real estate financial

2

institutions in the last few years

b. Risks and effects of this policy

3

c. The way to minimize this risks

5

d. Problems of investment funds

5

IV.

Market reaction of the risky practice of loans granting

6

V. Actual

problems

7

VI. Conclusion

8

VII. References

9

1

I.

Relevance of sub-prime mortgage market

a. Recent problems in the US-market

Favourable economic conditions over recent years have caused the

world economy′s growth to be above-average rates over past years

(RBA, 20071). Unusually low volatility, coupled with credit spread

remaining at low levels; have caused many asset prices to be at

historical high. The September quarter of 2007 has seen a sharp

increase in loan arrears in the sub-prime market, particularly residential

mortgages in the United States, as well as an increase in volatility in

other market, despite having a strong growth. The global markets

recent strong growth and performance in the past four years may be

attributed to low inflation rates and greater macroeconomic stability,

causing term and credit risk premiums to be lower, and the strong

developments in Asia, influencing pricing (RBA, 20071).

Sub-prime mortgages are offered to borrowers who, through poor credit

history or unstable incomes, do not meet the requirements of more

credit worthy mortgages. High interest rates, poor credit ratings, and

financial circumstances make sub-prime lending risky for lenders and

borrowers. This lending of money, with extremely tough conditions, can

lead to default, as the borrowers can not meet the terms on contract.

As the availability of teaser rates started to decline, the American

housing affordability reduced, causing housing prices to drop. As

housing prices fell, a Negative Momentum Effect took place causing

property prices to fall further, leaving borrowers with a mortgage that is

worth a considerable amount more than their house or asset. This

unbalance resulted in debtors `walking-out′ of mortgage contracts

(Dougherty et al., 2002). Defaults in sub-prime mortgage contracts

have led to the credit crisis in the United States, as lending companies

were falling into bankruptcy. This not only resulted in a sub-prime crisis,

but also banking, liquidity and collateral crises, which in turn has lead to

a crisis of the central bank (The Economist, 2007). These effects and

crises caused financial problems in the United States, and have led to

problems within global and Australian financial markets.

b. Reaction of the stock markets in Australia

Initially the Australian stock markets fell by 7-8%, due to the US credit

squeeze and its consequences within Australia (ASX, 2007). Since this

fall, the Australian and global markets have recovered strongly to be at

roughly the same level prior to the drop.

II.

Structure of the mortgage markets

c. Loan policy of Australian banks and real estate financial institutions in

the last few years

To describe the home loan policy in Australia we rely on information

from the company websites of the four major banks (ANZ Banking

Group, Commonwealth Bank of Australia, National Australia Bank,

Westpac Banking Corporation), former building society St. George

Bank and one of the most important loan companies RAMS Home Loan

2