Wednesday, October 01, 2008
The Creation of the `Credit Crunch'
So much has been reported about the current financial markets crisis gripping the US and other Western countries. The credit crunch heralded the arrival of the global financial crisis. But then, what was the root cause? Was it cheap money? Was it naked greed? Was it regulatory lapses or short termist incentives involving bonus schemes by banks? Undoubtedly, it cheap money caused the current financial crisis.
It is well documented that following the 9/11, it was feared that the US economy would plunge into a recession. In fact, the US economy did slow to a near standstill. Anxious to sustain the economy, the Federal Reserve (US Central Bank) ended up cutting interest rates 11 times from more than 6 % registered at the start of the year to less than 2 % at the end. Further, in 2002 and 2003, the Fed maintained unprecedented low levels. With inflation below 2% in the UK, the Bank of England Monetary Policy Committee maintained equally low level of interest rates. This action on both sides of the Atlantic gave birth to the cheap money culture; that is, it became easy and cheap to borrow and live on borrowed money.
As expected, financial institutions made heavy capital of this situation, by creating innovations involving several financial products in order to maximise advantage and increase their profit margins. Undoubtedly, most of the products existed but were re-engineered. For example, the Asset Backed Securities (ABSs) which are at the heart of the current crisis work on a simple business principle that has been around for decades. However, this business principle of funding became a problem when cheap money made it possible to include sub-prime mortgages.
HOW ABSs Work
First, the conventional way to fund mortgages is through two primary sources of capital equity and retained profits and debt financing by way of bond issue or bank loan. However, there is another way of funding not only mortgages but also car loans, store cards, personal loans and car loans etc which gained momentum with cheap money . To illustrate how this method of funding works, let’s take a mortgage lender who issues mortgages using existing funds. Once the funds have been exhausted, the only way further mortgages can be issued is if shareholders invest more capital - borrow from other financial institutions or simply wait until enough funds have accumulated from monthly repayments. Clearly, this form of funding is slow and mortgage lenders struggled to cope with demand because of illiquid properties in which their investments were tied up with. Now the idea behind ABSs financing is to free money which is usually tied up with illiquid mortgage properties for fresh lending. So once funds have been exhausted, they then bundle these mortgages into mortgage books and sell them to investors at a profit for cash. This freed cash becomes available for further lending. The books of these mortgages have no value in themselves but their values are derived from individual mortgages that constitute these books. For this reason, ABSs are also a form of Derivatives and therefore, became the answer to liquidity problems faced by mortgage lenders. The same principle is replicated for all form of credit; be they car loans, personal loans, store cards and credit cards, And given that even very little capital can be turnover several times within a short period of time, it became very lucrative to make money and attracted the participation of Standard Rating Agencies, Insurers and giant Wall Street investment banks.
The Participation of Standard Rating Agencies, Investment Banks and Insurers
First, Rating Agencies saw the opportunity to make money by rating mortgage backed securities. These agencies gave the ABSs a big boost or rather a stamp of approval that these instruments were low risk with high returns, hence, safe for investment by both local and international investors. Again cheap money had resulted in safe havens like TBs and bonds unattractive, so investors were looking for high yielding investment opportunities. The attraction of ABSs due to stamp of approval was the beginning of spreading of these poisonous assets throughout the world financial system.
Second, with so much money available to lend coming from surplus world soon there was no more prime customers or credit worth borrowers. This opened a window of opportunity for undated form of ABSs. Sub prime mortgages lenders specialising exclusively in issuing mortgages to people with bad credit record or risk borrowers mushroomed mainly as subsidiaries of big banks and companies. Sub prime lenders would bundle sub prime mortgages issued into mortgage books and then passed over to investment banks for underwriting and distribution to investors using their international branch networks. A good proportion of these bundled instruments magically became investment grade A. This is because they earned lucrative fees. Insurers too, joined by providing low premium cover for investors, though some shrewd investors took advantage and passed the risk to insurers for low premiums.
The US, UK Mortgage Market at its Peak
Given the bewildering array of opportunities provided by cheap money and participation of financial giants, it was not long before basic requirements like proof of identity; proof of income and proof of resident were ignored by mortgage lenders. The reason was simple; these mortgages were not held in their balance sheet. As well, crazy products were introduced such as 125% mortgages, which mean that not only does a lender funded your house purchase for a princely sum, but they also gave you extra capital to spend as you wish. There was no waiting time to raise deposits and mortgage related fees and costs such as solicitors fees, stamp duty etc., would normally be paid for. Other crazy mortgage products were Self-certification mortgages tailored for those who can’t easily prove their income but this product became the most abused. It meant any one desperate for a mortgage would provide his/her “head income” to qualify for an expensive property just by income declaration requirement. Other suspect mortgage products are interest only mortgages and incentives such as vender/builder gifted deposit all contributed to loosening of lending standards. Specifically, the building industry gave incentives to buyers in order to sell their stocks quickly.
Again with giant Wall Street financial institutions involved in profiteering from this opportunity, who would have blown the whistle or bell the proverbial cat? By freeing up property-lending standards and conducting aggressive marketing, mortgage lenders initiated a greedy race to make money by individuals and corporations. This then exacerbated artificially low interest rates and pushed property prices to record high. For example, in the UK, the average national properties prices doubling time were reduced to 7 years. Specifically, in London and the South East, doubling time decreased by 4 years. This means that if you reside in London you can buy a house for £250,000 in 2004 and in 2008 sale the same house for £500,000 pay back the lender their £250,000 and pocket the balance. As a result of this, 20% on the UK millionaires list have been borne out of the property market. The magnitude of funding which found its way into the sub-prime mortgage sector in the US amounted to $650billion in 2006 alone.
By the middle of 2006, cracks began to appear. Intensified inflationary pressures due to unanticipated world oil price hikes imparted upward pressure on the Fed to raise interest rates. A wake up call for the Fed and as so often in the past, the move was too little too late. Too much cheap money had been taken in form of mortgages, car loans, credit cards, personal loans store cards so any upward move for interest rates would shaky the financial system. But Fed had no choice but to deal with inflationary pressure by raising interest rates. This inevitable action was brought to bear on sub- prime mortgage borrowers, it did not take long before so many sub prime borrowers started to default resulting in foreclosures in the US. With so many houses off loaded on the market for sale due to foreclosures, the bubble was over and property prices rose sharply (stumble a term technically referred to as a bubble burst). Initially, there was still denial, but it did not take long for investors to holding mortgage books to realise that their assets had become worthless with falling property prices.
All in all, investors pulled out their money out of ABSs, and as a result, funding sources dried up almost immediately. Ironically, banks themselves added salt to the wound by not trusting each other in their money market transactions. This uncertainty and lack of confidence in each other gave way to a fully blown credit crunch.
Now the acid test for investment banks and banks caught up holding huge ever falling illiquid assets. The Basle II has to be applied these assets have to be marked to current market value and not at historical cost. So these institutions started to declare themselves by writing off these assets to profit and loss accounts resulting in huge loses and setting stock prices from New York, UK, Europe, Asia all stumbling and causing the current financial turmoil.
Cheap money gave able time for Wall Street banks and their counter parties to create financial instruments with risks perceived to have been diversified away from banks balance sheet, hence outside regulatory control. The impact of raising interest rates after getting used to low interest rates exposed what was hidden under cheap money, now turned into a financial-driven recession abating strategy. Now with weak financial systems and threats of recession as real as after 9/11 it is time for serious thinking. Quick fix rescue plans may not be the solution or at worse, blaming the greedy.
(Mr. Lovely Mwambazi is a financial consultant with considerable experience of South African (especially Zambia) and UK financial business markets, specialising in the mortgage and insurance/protection sector respectively. He holds degrees in Economics and International Finance, apart from various professional qualifications. His most recent presentations include “The Origin and Implications of the Credit Crunch at Household Level” and “The Need for Financial Protection for loved ones and Businesses”. – Mr Lovely can be contacted by email:email@example.com)