This article appeared originally in Gulf News: link to original article
Allow me to take you back to 2008, the peak year of the latest financial crisis. This article is not going to be about that… at least not in its entirety.
In the US, individuals took out loans to buy homes — mortgages. Banks were getting their money back, with profit, but that could take decades depending on the payment plan.
To make things more interesting, banks started bundling those mortgages together to create something similar to an investment fund. Then, banks issued bonds on those to get some of their cash back today, and let interested investors wait out the mortgage years.
Banks being banks would go ahead and lend the money made from bonds issuance, and so on. What differed in 2008 and the years preceding the crisis are two main things:
1. Less scrutiny of mortgage applicants, and
2. Adjustable rates — a bank representative quotes you a fixed rate or a ‘teaser rate’, which expires in a few years and an adjustable rate kicks in.
As such, the next rate could go up or down depending on market conditions, increasing or lowering your monthly payment.
I lately decided to search and shop for a good mortgage loan with a favourable rate and payment conditions. And in the process, I found out that a bank, which signed an agreement with a government housing programme, offers a much easier way to combine all of the above and saves you the trouble of having to go around speaking to other bank representatives.
There was one issue though. An adjustable mortgage rate kicks in starting from the second year, with a fixed rate for the remaining years plus the UAE’s central bank’s Emirates Interbank Offered Rate (Eibor). This has a good side and a bad side.
If interest rates go down, you win by paying a lower monthly payment. If they go up, which is most likely given the Fed’s interest rates’ direction, you lose by paying more per month. A disclaimer here though is that many could argue that a small uptick in interest rates shouldn’t be an issue if the amount isn’t high.
Correct, especially as I don’t expect a major rate hike by the Fed anytime soon. Though with mortgages, the amounts are normally high with extended paying back durations, and an interest rate trending upwards is not in your best interest when you know it could be the case for the near future.
There is one more concept to be considered here and it’s the time value of money. If we assume that interest rates go up and keep going up for the next 10 years, after which they drop, the drop later on would be insignificant as the savings, in today’s money value, will be basically worthless.
So why do banks go for adjustable rates, including the one mentioned earlier? It has to do with lending versus borrowing for banks. And so the sub-prime crisis, and the idea behind it in the years leading to 2008, was that banks can get their money today if they issue bonds to investors, and as long as people don’t default and the mortgage income keeps coming in, there shall be no issues.
The defaults were mainly driven by higher monthly payments due to higher adjustable rates, leading to a collapse in the US housing market. Besides the housing market meltdown in the US, the meltdown went global due to:
1. The size of the US housing market, and
2. Investments by individuals and institutions in the mortgage bonds issued.
I am not hinting here that adjustable mortgage rates could lead to a housing bubble in the UAE and possibly a housing crisis. It could, however, create multiple issues of default at individual levels, which could affect the consumer economy. The last thought that I want to leave you with: Are we going to see a sub-prime mortgage bond issuance in the UAE?