The Effect Of Sub Prime Mortgage Crisis

Subprime mortgage exist to provide loan to those borrower who are not qualify for the conventional mortgage. It is a type of mortgage which is granted to the borrowers with poor or lower credit rating (Edoardo Turano, 2006).Generally, it offers interest-only loans because it is easier to afford. The loan does not require any principle to be paid in the few several years of the loan. Borrowers are always in the hope that they can make the payment before any principle is subjected. This will reduce their monthly payment. If they cannot fulfill the payment, they are usually defaulted since they cannot make the higher payment (Amadeo. K, n.d.).

Individual who have a financial problem before are classify in the group of higher risk and therefore they have a greater difficulties to obtaining credit, especially for large purchase such as house and car. These individual may had lost their job, medical issue, low income, large loans relative to the security property or any other unpredictable event which will cause a major setback in finance. As a result, late payment or foreclosures will happen. Lender with subprime mortgage bears the higher risk. In order to protect themselves from facing too many losses, subprime lender charge interest rates above the prime lending rates (Edoardo Turano, 2006).

1.2 Historical and background

Subprime mortgage industry has grown in the year 1990 (wikinvest, 2010). The credit market is evolved towards more efficiency. Subprime lending evolved with the realization of a demand in the market place for loans to higher-risk borrowers with imperfect credits history.

The subprime was originates in the year 1993. The low interest rate and escalating of home price have bring many companies enter into the market. The market had enjoyed the unbridled growth and profitability, but the current environment is become more competitive. However, through these years the business had experienced the attractive of profitability in the early years and follow by the indigestion reduction in profit margin in the latest year (n. a, 2006). Instead of getting lower, the subprime mortgage grow higher and higher. The deepest subprime mortgage falls in the year 2009. In year 2009, gross domestic product in the country is in the negative sign. This shows that the country is in the tremendously bad situation. Market participant should take initiative to emphasize on cost control and cost reduction (n. a, 2006).

1.3 Drivers of subprime lending

Home price that appreciate since the mid-1990’s until today is seem to be unchangeable trend. This make the individual assume that the home price will always maintain in the same level or even getting higher. Individual predict that they will get profit if they do the investment. This make them offset the risk that they have to bear when they make the subprime lending (wikinvest, 2010).

Adjustable-rate mortgages and interest rates had brings the evolution of subprime lending. Towards the end of 1990s and the mid-2000s, ARMs is become popular in the United States mortgage market especially in the subprime lending. ARMs provide the feature of variable interest rates. Subprime lender start to promote ARMs as to replace the traditional fixed interest rates lending. It is a tease that misleading the subprime borrowers with the assumption that they are paying lower interest rate initially. ARMs can be benefit to borrowers when the interest rate falls after the loan origination. Though, borrowers are still need to bear with higher loan rates and monthly payment when the interest rate increases. With the steadily increasing of interest rates for continuously few years, it may found that borrowers are unaffordable with the payment and lender are profitable. As a result, when there is foreclosure of subprime mortgage rate drastically, lender will face the financial difficulties or even bankruptcy (investopedia, 2010).

In addition, the lax lending standards also drive the subprime lending until today. Two decades ago, subprime borrower will be denied credit because lenders are restricted by the rigor lending standards. The law prevented lender to charge high interest rate to compensate the risk the bear. However, the adoption of the Depository Institutions Deregulatory and Monetary Control Act in 1980 eliminated rate caps and made subprime lending more feasible for lenders. The increase acceptance of securitized product means that the lender is taking lesser risk compare with before. Lenders are begins to lower their requirement when the standards fell. Furthermore, when they are more investor demand for lending, there will be capital constrained and unable to meet the demand. This will also makes the investor to have higher-yielding securities which could only be bring out by the issuance of subprime loans (wikinvest, 2010)

1.4 Effects to the economy

The world economy has been growing up at a rate unmatched since the 1970s. Due to that, Malaysian economy has grown rapidly together with the world economy. Although, the happen of the sub-prime mortgage crisis currently threatens to derail the global financial system and the economic stop to growing after this. This recently situation had threatens and provides a challenging avenue to which the Malaysian financial system and economy would be stress-tested by negative external forces. Amidst the financial turmoil and partial nationalization of financial firms, Malaysia’s financial system appears to be resilient (Jamesesz, 2009).

As stock market around the world circulate from the prospect of a U.S. economic recession, and banking institution is the main economics suffer great losses from their investment in securities that are backed by sub-prime mortgage in the U.S., the Malaysia economy in the face of all these global economic woes, stands rebound back.

Though facing the difficulties, U.S. is still remains to be the largest trading partner with Malaysia. The current recession situation of U.S. might mislead others that U.S. situation would negatively impact Malaysia. However, real situation reveals that Malaysia had lessened the dependence on the U.S. as a consumer of Malaysia goods. Others than that, trading between Malaysia had with China and European Union had been increasing over U.S. in the past few years. Gross exports by Malaysia to the U.S. have gradually declined from 18.8 percent of Malaysia’s total gross export in 2004 to 16.1 percent in the first nine month of year 2007.

Besides, Malaysian banks do not get impact from the sub-prime mortgage crisis in the U.S., as the collective exposure of Malaysian bank to the sub-prime mortgage-backed CDOs is estimated to be less than US$100 million. With the strength and characteristics of Malaysia, we do believe that Malaysia economy is able to withstand the anticipated slowdown in global economic growth (Washington Times Global, 2009).

2.0 Literature Review

2.1Gross Domestic Product

2.1.1 Introduction to GDP

According to McConnell, Brue and Flynn (2009), Gross Domestic Product can be defined as the market value of all final goods and services make within nations during one year.GDP can be divided into nominal GDP and real GDP. Nominal Gross Domestic Product is measured by using current price while Real Gross Domestic Product calculated by the base year price. Nominal GDP will have problem that is the GDP will rise year to year but output did not increase. Real GDP solve the problem of nominal GDP by correcting the prices. From Real GDP, it compares real number of year to year which can know clearly and realty changes in output.

GDP can be measured by two basic ways that are expenditure approach and income approach. According the theory,the expenditure approach measure by total up all cost that used on final goods and services. Those spending include Personal consumption expenditure (C) , Gross Private Domestic Investment (Ig), Government purchases( G) and net export ( Xn) (McConnell, Brue and Flynn, 2009). C is consumption by individual or household’s expesenses includes goods (durable or non-durable) and services. Ig refers the spending on all capital goods. G is spending on public goods and services by government while Xn is cost that used in buy the products and service make within nation. But in Malaysia, expenditure approach consists of private expenditure, public expenditure and import and exports of goods and services. The private and public expenditure can further divide to investment and consumption (Economic Planning Unit, 2010).

Another method to measure GDP is income approach. It totaling up all income includes compensation of employee, rents, interest, proprietor’s income, corporate profits and taxation on production and imports (McConnell, Brue and Flynn, 2009). Compensation of employee is wages or salary of labor service. Rents are income from property or other rental inputs. Interest is the household receive from loan. Proprietor’s income is income from incorporated business .Corporate profits is profit of corporation(McConnell, Brue and Flynn, 2009).

Besides that, GDP also a indicator of a country’s economy growth whether in good or bad condition (Investopedia,n.d.). GDP can has large influence toward economic. Economic growth can be defined as either an increase in real Gross Domestic Product (GDP) or an increase in real Gross Domestic Product (GDP) per capita (McConnell, Brue and Flynn, 2009). It is calculated as a percentage rate of growth per year. Generally, the formula below was used to measure the economic growth in a country(McConnell, Brue and Flynn, 2009):

Real GDP current – Real GDP previous X 100

RGDP previous

Malaysia economic growth has rapidly sturdy in the early 1990s. Average of GDP is about 7 to 9 % in early years. The growth of this few years maintain between 5 to 6 % until Malaysia suffer in Asian Financial Crisis 1997 and Subprime Mortgage Crisis. (Dunhill,n.d.).Malaysia main economic is exported goods and services to other countries mainly United States. But recently, Malaysia changes their economic model from export oriented to service oriented economy and to more high income country. The country has a stable economic growth will also has a significant good GDP growth.

The Malaysia economy has much related to United States economy. When United States faced the housing bubbles in year 2008 and burst the price of housing market (Dunhill, n.d.).United States faced recession on housing market. Recession is when a GDP growth of a country continuous decline at least 3 quarters. Malaysia has some significant influence from that also (Dunhill, n.d.). Malaysia faced deeply recession during year 1997 till 1998 on Asia Financial Crisis. Malaysia’s GDP influence much by shrink more 7 %. The recession continue happen in Malaysia in year 2001 and year 2009.The recession occurred when a country’s GDP continue In year 2009, Malaysia government predicted GDP decline 3% and economists believe that it will recover in year 2010 (Travel Document Systems, n.d.).

U.S. Subprime Mortgage Crisis occurred in year 2008 and lead to one of factor cause recession in year 2009. Subprime Mortgage is interest only loan offering, easy be afford by many and does not need to pay principal with first few month. The borrower believe themselves that can get refinance before paying the principal but mortgage borrower cannot afford to pay the monthly payment which keep increasing, they forces to default with high payment and Subprime Mortgage Crisis is occurred(Amadeo, 2010).

U.S. Subprime Mortgage Crisis has little impact to Malaysia baking’s sector. Our impact not much as impact happens in U.S for other sectors, some influence and loss a lot such as manufacturing sector. It is no economic factor rather than globalization factor which cost competition with those lost cost based country (Dunhill, n.d.).

2.1.2Comparison and Analysis of GDP from 2007-2010

2007

2008

2009

2010

GDP (%)

6.3

4.6

-1.7

8.9

Statistic Data taken from www.epu.gov.my

Subprime mortgage crisis that happened in United States has been worsen during the year of 2007, so being an open economy, Malaysia and other countries are not immune from any crisis, it has a serious negative impact on the economy of Malaysia. Recession is took place when a GDP growth of a country is moving negative steeply for at least 3 quarters. . Anyway, there are some certain industries that can be registered as a recession like housing segment or manufacturing segment. But overall can be still in positive if other industries do well. Consumer spending is still high and the confidence index also high till late December of 2007. For instance, construction sector has been increasing from -0.5% to 4.6%; mining is one of the major sector to Malaysia’s income, useful in recovering the economic growth and important driver to Malaysia income. The percentage of mining sector has been increasing from -2.7% to 3.3%; services sector has been increasing from 7.3% to 9.7%. Since those sectors are still doing well, thus, the recession has no any serious impact on the GDP and the GDP during 2007 is still maintained in positive value.

During 2008, the GDP has dropped from 6.3% to 4.6%. The other main sector which is mining has dropped steeply which is from 3.1% to 1.9%; services sector also decrease from 9.7% to 7.7%. While another component of GDP is net export. The percentage of export during the year of 2008 is 0.9% as the percentage of import is 2.3%, thus import is much larger amount than export. Then, it is known as net export deficit. When there is a recession in United States, everyone from United States wishes to save money and thus will decrease their spending. When spending decrease, export to Malaysia will be reducing too, thus GDP will be lowered down since export is one of the determinant of GDP.

Why does the positive GDP from the year of 2008 turned to negative GDP during the year of 2009? It is because the crisis that caused by subprime mortgage has continuously reducing the income of Malaysia while keeping the expenditure higher and higher due to the stimulation measurement of government’s economic. Firstly, agriculture, services and manufacturing sectors have been going to the recession especially manufacturing sector. Its percentage from positive value drop to negative value. While both of the percentage of export and import drop until negative value. Its percentage of export is -12.3% and its percentage of import is -10.4%, thus import still larger than the amount of export, we can conclude that the deficit net export is still maintained. Since the deficit net export has became more and more serious, thus the GDP turn from positive value to negative value.

In the year of 2010, current year, our Malaysia economic has turned back to better compared to last year since the latest GDP measurement for our country is 8.9. it turns the negative value to positive value, obviously, recession is getting recover. All of the sectors such as agriculture, mining, manufacturing, construction and also services have turned to larger percentage in positive value. While about the export and import, although there is still net export deficit, the percentage of both import and export have turned to positive value. Thus, the income or revenue of Malaysia during 2010 is the largest amount compared to the amount of revenue last 4 years.

Based on budget 2011, there is one highlight which is the extension of income tax deduction incentive for investors and income tax exemption for companies undertaking food production activities until 2015 (NST, 2010). When the tax is decreased, this will attract more and more investors to invest in our country thus may lead to growth of our country, Malaysia’s economic since foreign investment is one of the determinants to improve our economy. Thus, our GDP might be improved throughout the year of 2011.

Another highlight included in the budget 2011 is Allocation of RM135 million for basic infrastructure to encourage farmers participation in high value agriculture activities including swiftest nests (NST, 2010).Since agriculture is one of the major sector in determining GDP, so the economy might be improved during the year of 2011 when the agriculture activities are getting more and more active.

2.2 Inflation

2.2.1 Introduction of Inflation

In economics, the definition of inflation is the increase in the general level of price of the products and services over a period of time. Inflation rate on the other hand is the measure of inflation, the rate of increase of price index for example, Consumer Price Index (CPI). It is the percentage difference rate of change in price level over time. (Articlebase, 2010)

Inflation is measured by comparing two sets of goods at two points in time, and computing the increase in cost not reflected by an increase in quality. There are, therefore, many measures of inflation depending on the specific circumstances.

The most well known are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy. The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. Mainstream economist views can be broadly divided into two camps: the “monetarists” who believe that monetary effects dominate all others in setting the rate of inflation, and the “Keynesians” who believe that the interaction of money, interest and output dominate over other effects. Other theories, such as those of the Austrian school of economics, believe that an inflation of overall prices is a result from an increase in the supply of money by central banking authorities.(Trading economics,2008)

2.2.2 Comparison of Inflation Rate between 5 Years (2006-2010) in Malaysia

Sources: Data taken from www.epu.gov.my

The inflation rate in Malaysia was 3.6% for the year 2006 and the following year, a drop of 1.6% resulting the Consumer Price Index (CPI) for the year of 2007 become 2.0%. This drop shows the strength of the Malaysian economy as the inflation rate stable down. The Malaysian economy was stronger and more resilient. (BNM, 2007) The effects of the subprime mortgage were not showing yet. However only a year later, the CPI spike up and had risen to a staggering 5.4%. It’s the direct effect of the subprime crisis to the Malaysian economy. The following year however, the inflation rate recorded the lowest for the 5 years and a mild upward trend on the estimated inflation rate for 2010.

The reduce in inflation rate is largely affected by the stronger growth in Malaysian economy for the final quarter of the year. Both private consumption and gross fixed investment grew faster in 2007 than in 2006. Besides that, private consumption increased its growth rate from 7.1% in 2006 to 10.7% in 2007. The growth in investment in Malaysia also increased from 7.9% in 2006 to 9.5% in 2007. Government consumption also increased its growth rate from 5.2% in 2006 to 6.5% in 2007. Moreover, the overall growth rate of domestic demand increased from 7.0% in 2006 to 9.7% in 2007. The stronger performance of domestic demand helped keep the GDP growing at a similar rate than the year before in the face of an important drop in the rate of growth of exports, from 7.4% in 2006 to 2.1% in 2007. All these resulted to a lower rate of inflation for 2007. (UNESCAPE, 2008)

In the year 2008 however, it is recorded a significant rise in inflation rate. This is cost push inflation as the government decides to increase subsidies of oil and gas but raise the (road) toll rates, and the demands for fare hikes from public transport operators are granted. This is to ease the inflation that has heavily impacted the people. (Funsupermart, 2010) The subprime mortgage that affected America’s economy proves to have a domino effect as country all around the world face a global economy crisis. The only country that was not affected was Bangladesh as they are a fairly independent country. (Trading economic, 2008) People are more afraid of the effects of the housing slump, sub-prime loan crisis and credit crunch in the US economy spilling over to the real economy worldwide and of course worldwide inflation.(CKTEN, 2008)

For the year 2009, a deflationary scenario occurred towards Malaysia’s consumer price index (CPI) since June 2009, this is mainly due to the higher base effect in the second half of 2008. As at end of October 2009, Malaysia’s CPI was still within the deflationary territory of -1.6%. The average inflation rate for the year is 0.6%. Estimated inflation rate for the year 2010 is 1.9%. (Fundsupermart, 2010)

It is clear that the inflation rate have shown an upward trend from 2006 to 2008 as the subprime crisis is taking its toll towards the economy. However, economics have expected the current state for the year 2010 is expected to be looking good.

2.2.3 Exchange rate

2.2.3a The relationship between inflation and exchange rate

During the subprime mortgage period, the inflation rate in 2007 is 2.0 increased to 5.4 in year 2008.(EPU, 2010) Normally, the inflation rate increased from 2.0 to 5.4, the currency value also will affect by the inflation crisis and then our country currency value will depreciate in its value. (EPU, 2010).However, our country exchange rate becomes lower against the US dollar. Refer to the chart below; the exchange rate in 2007 is 3.438 per US dollar. In year 2008, our Malaysia ringgit exchange rate is 3.333 per US dollar (EPU, 2010). This is because of US central banks started to inject billions of dollar into the financial market in order to make sure that the financial market can continue operating as well .Therefore, US dollar value will depreciate because of the large amount of money flow into the market and the purchasing power of the money will be decreased. In year 2009, the exchange rate of ringgit Malaysia per US dollar is 3.525 because the subprime mortgage is past and the United Stated economy starts to recover back.

2.2.3b Malaysian Government action to reduce the effect of Subprime Crisis

Besides that, most of the Asian countries include Malaysia have strengthened their external position which is maintaining huge foreign reserves, diversifying exports to foreign countries and running the account surplus during the subprime crisis. As a result, Malaysia currency becomes stronger during 2007 and into 2008 our economy can avoid inflationary pressures, especially from high commodity prices. Moreover, Malaysia currency value still able to remain stable during the subprime mortgage compare with United States and certain European countries is because of Malaysia had implemented the measurement on the cool property markets in recent years whenever prices threatened to become bubble. As a result, Malaysia was able to reduce the impact of subprime mortgage in 2008 such as the housing bubble in US.

The Inflation rate VS the Exchange rate in Malaysia from 2006- 2009

Sources: Data taken from www.epu.gov.my

2.3Unemployment Rate

2.3.1 Definition of Unemployment rate

The labor force consists of people who are willing and able to work (Economics, 18thEd). Those who are employed and unemployed while searching for jobs are included in labor force. International Labor Organization (ILO) defines “unemployed” as well as individuals above a specified age who without work (not in paid or self-employment), currently available for paid employment and actively seeking work. The unemployment level is defined as the labor force minus the number of people employed (trading economics, 2010). The level of unemployment divided by the labor force is the unemployment rate.

2.3.2 Types of unemployment

There are three types of unemployment. Frictional unemployment arises because there are people changing jobs. This may be due to the individuals being fired and searching for job or waiting to take the opportunities. There is always positive level of frictional unemployment even when the economy operates at full capacity although there may be offsetting job vacancies (the Canadian encyclopaedia, 2010). Besides, changes over time in consumer demand and in technology will lead to structural unemployment. Structural unemployment was viewed as a temporary and not a long-term feature of economic development, because the labor market left to its own left to its own devices sooner or later reaches equilibrium with full employment (Persefoni, 2008). IMF states that in recent decades it becomes increasingly apparent that this type of unemployment is neither temporary nor self-correcting (1999). Furthermore, cyclical unemployment is unemployment that caused by a decline in total spending and the unemployment rate moves in the opposite direction as the GDP growth rate. Unemployment raises when the demand for goods and services decreases and the falls in employment (Economics, 18th Ed). Full employment occurs when there is no cyclical unemployment which means there is only frictional and structural unemployment.

2.3.3 Data analysis

Sources: Data taken from www.epu.gov.my

The unemployment rate in Malaysia was last reported at 3.6% on September 2010(epu, 2010). From year 2007 to year 2010, the average of unemployment rate is 3.45%. The effects of subprime crisis can be shown on the year 2009 with the highest unemployment rate when there is a recession with negative growth rate. This proved that the lower the growth rate, the higher the unemployment rate and hence there is a trade-off between unemployment and inflation (Stockhammer, 2004, p.7).

2.3.4 Factors affecting unemployment

According to Sathish.k.Paul (2010), the higher of unemployment rate can be affected by several reasons such as population, illiteracy and ignorance, or lack of job. A huge number of population cause more people are able to be educated, when that were a lot of people being educated while the job offer for them are less will cause unbalancing and increasing of unemployment rate will occur. For those live in village or small town will become illiteracy because unable to provide a good education to themselves or next generation. Some child has to work since their house income is less. The lack of education and basic needs cause them feel basic needs are much more important compare to education. This ignorance will lead them unable to find skilled job or unemployed even in industry because industry nowadays may need skill or basic knowledge of education to be employed. Although our country have a lots of development sector, but the lack of development in certain industry cause job offering are not enough to meet the population then seeking for job. Moreover, the global economic meltdown, many industry affected and face downturn or bankruptcy, this tragedy not only affect industry but also contract laborers. This lead to high unemployment rate because many labors are losing their work.

2.3.5 Problems caused by unemployment

When that is not enough skill employment or not enough jobs available for them, there will increase of unemployment rate and occurs negative effect. The rich country will become very richer and poor country become very poorer. So, this may cause imbalance in job available between rich and poor country. Social problem will occur such as some unemployed people do not have income and start to stealing or robbing other people money (Sathish.k.P, 2010). People will full of confidence when both money and success in job satisfy them. However, confidence will reduce and lack of self-esteem when they are unemployed. In this case, unemployed will less confidence and reduce their interest. When the time of unemployed getting longer, the stress for those them will getting serious. Unemployed people will not care about their health and this leads to unhealthy level because the stress occurs. Another effect is the losses of enthusiasm will cause the willpower decrease (Article Base, 2010).

2.4 Current account

2.4.1 Subprime crisis cause recession

The US Subprime Market Crisis has already resulted in US Economy Recession. In January 2008, the US Federal Reserve slashed interest rates from 4.25% to 3.5%. This result the biggest overnight cut in more than 25 years (Rebecca Turner, 2008). In Malaysia, this US Federal reserve is same meaning with the Overnight Policy Rate (OPR). In the age of globalization, no country can remains isolated from the fluctuations of world economy. US recession lead by subprime crisis was effects on the global economy. Malaysia is bearing the negative effect of the US recession. The negative of it can be proving by the declining of Malaysia growth rate. According to the table of key economic indicators in Malaysia, we realize that Malaysia’s average quarterly GDP Growth was 1.18 percent between years 2000 to year 2010. However, the historical low of GDP growth rate -7.80 percent was show in March of 2009.

A country’s interest rates rise and its currency appreciate as foreign investors seek higher returns than they can get in their own countries (William C. Spaulding, 2005-2010). Based on the graph below, when the subprime crisis in 2007 occurs, Federal Reserve of US has actually started to lower down its interest rate to cushion a possible recession. Thus, Bank Negara Malaysia (BNM) was face pressure to lower its rate to reduce the upward pressures on Ringgit that may hurt our export. This is because if exchange rate overly high, it becomes more expensive for foreigners to buy our goods (Zaur Hasanov, 2009).

Interest rate in America for the year 2007 and 2008

Sources: Federal Reserve Board; Bloomberg; JPMorgan Chase; BIS calculations.

2.4.2 Currency and Balance of Payment

Balance of payment (BOP) is accounting record of keeps track both the payments and receipts from foreigners. Current account included sum of the balance of trade (net export), net factor income, and transfer payment. In theory, the exchange rate will have an impact on the current account (anonymous, 2010). An appreciation of ringgit, in another way mean it become cheaper for investors to purchase import goods. It will lead to the decrease in net exports. Meanwhile, the slash of the net export will lead to current account deficit. In summarize depreciation in the exchange rate should improve the current account and an appreciation should worsen the current account. If we apply the theory into the real Malaysia economic, the data shows that the current account balance in 2009 is decrease from 129,513 to 112,139. Although it is a current account surplus, but the Balance of payment is decline sharply. The subprime again prove that it is effecting the Malaysia economy by reduce the balance of payment.

In conclusion, subprime financial crisis has cause our country drop indirectly into recession by the global economic effects. During the subprime crisis, US were decreasing their interest rate to stabilize the possible recession. It has stimulated our country’s to decline the interest rate also to eliminate the export affected. Thus, it was cause the current account deficit. Although the subprime crisis is happened in year 2007, but Malaysia has been more effected in year 2009.