The financial turmoil of the past year or so has been a learning experience at least, the world’s last optimist might say. Terms like default, bailout and sub-prime have crept out of economics lectures and entered common usage. A sushi restaurant on Dublin’s quays now sells a ‘Credit Crunch Lunch’, for €17 with a glass of champagne, as if to flaunt the decadence of a dying empire. But to your average Joe the plumber (see facing page) these are little more than buzzwords: foreign and mystifying concepts to pin on the wall and petulantly throw darts at.
Meanwhile the blame game continues. In the previous issue of World Review one writer argued that we shouldn’t be so quick to blame the bankers for the recent market mayhem. The great economist John Maynard Keynes, writing during the Great Depression, cynically lamented that having a backbone seems to be incompatible with being a banker. “A sound banker is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him,” he wrote. In other words, bankers go with the flow and stand or fall together. So what kept them on their feet until now, and how did they lose their balance?
In the beginning of 2007 the odd expression ‘subprime’ began to feature with increasing regularity in business headlines, before newspapers turned inside out and began to put their business section on the front. The Oxford English Dictionary rushed to include it in its June 2008 update and found it has only existed in its current usage for fifteen years. A subprime loan is one offered to a customer with a poor or nonexistent credit history who doesn’t qualify for a normal loan. The higher interest rate attached to subprime borrowing is intended to account for the increased riskiness of the individual. Subprime customers could range from those with a poor credit rating because they missed a few credit card payments to the extreme scenario of what bankers disparagingly call NINJAS: no income, no job, no assets.
Such loans are a relatively new and risky phenomenon. The typical Victorian banker was one whose only interest was in making profitable and necessarily secure loans. One might question why a reputable bank would be interested in giving out a loan when there was a real chance it might not get its money back. Indeed, until recently banks wouldn’t touch NINJAS. So what changed? Why the move toward giving such risky loans?
Subprime loans are a relatively new and risky phenomenon. One might question why a reputable bank would be give out a loan when there was a real chance it might lose its money. So what changed? Why the move toward giving such risky loans?
Essentially we assume that all bankers are rational profit maximisers, who, when presented with an opportunity to make a quick profit will immediately take it. If a banker can issue a mortgage, receive the payments for it and simultaneously abdicate responsibility for it, then this is an opportunity not to be missed. The innovation which allowed them to do this was a financial instrument called a mortgage-backed security. A mortgage-backed security works by bundling up thousands of similar mortgages into a package which can then be sold off to another financial institution. The bank which sells the mortgages benefits from an instant cash injection, and the buyer gains a constant stream of mortgage repayments for the lifetime of the loans.
Since the mortgages are traded in bulk, if a few customers end up defaulting on their payments the effect is less crippling to investors. Essentially such packaging allowed banks to diversify all non-systematic risk, which is the risk associated with the possibility of a particular individual defaulting on their repayments. Mortgage-backed securities effectively allowed banks to sell off their risk, and dicey subprime loans were traded with increasing frequency. A mortgage taken out on a home in Wicklow through an Irish bank could be sold to a Belgian bank, which in turn sold it in to a U.S. hedge fund, which passed it on to a Japanese consortium.
Harry S. Truman, the U.S. president who presided over a fraught upheaval of the U.S. economy after the Second World War, kept a sign on his desk that read, “The Buck Stops Here”. Global trading of mortgages on a massive scale muddied the waters of responsibility. It became less and less clear where the buck stopped and where responsibility really lay. This in turn led to what became known as predatory lending: what economists call the deceitful practice of seeking out borrowers who have little chance of comfortably making repayments. According to the ‘blame the bankers’ view of the crisis, banks unscrupulously signed up clients to loans they couldn’t afford and then casually sold these toxic loans in bulk to investment companies, hedge funds and other banks. By the time the customer found himself deep in debt and unable to keep up with his mortgage repayments, it was already another bank’s problem.
Global trading of mortgages on a massive scale muddied the waters of responsibility. It became less and less clear where the buck stopped.
The dizzying game of musical chairs was best described by Charles Prince, the former CEO of Citigroup. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” Mr Prince said in July 2007. Four months later he resigned as Citigroup CEO when the company’s catastrophic third quarter losses demonstrated beyond doubt that the music had long stopped playing.
Risk assessment companies have shouldered their share of the blame for the crisis. They are accused of making overly-optimistic predictions, founded on enthusiasm for the ability of mortgage-backed securities to diversify risk. In an atmosphere of unbridled confidence, some companies paid scant heed to the apparently unlikely risk of a general economic slump. Certain agencies were more at fault in this respect than others. So called cycle-neutral rating, practised in particular by Moody’s, meant giving little emphasis to the cyclic ups and downs of the business cycle. Unfortunately, the housing market is particularly vulnerable to this type of risk.
When the American housing bubble finally burst, property values dropped, interest rates rose, and suddenly the NINAS couldn’t meet their mortgage repayments. A wave of foreclosures swept the States, and within a matter of months ‘For Sale’ signs became as ubiquitous on American front porches as Obama and McCain lawn signs. The downturn in the housing market triggered a precipitous fall in the value of these securitised assets held by various banks and financial institutions, and as such these losses soon made their way on to banks’ balance sheets. Those engaging in a high-class game of pass the parcel began to be found out.
The crisis gained momentum at the beginning of this year as the major global financial groups grimly informed their shareholders of the massive losses they had sustained. The collapse of investment bank Lehmann Brothers marked the biggest bankruptcy in US history, while a wave of forced mergers saw Merrill Lynch acquired by Bank of America and Bears Stearns acquired by J. P. Morgan Chase. Meanwhile Swiss bank UBS had written down the value of its assets by almost $40 billion dollars by April, in the process acquiring the moniker UBS (Used to Be Smart). Fannie Mae and Freddie Mac, the two institutions at the centre of the subprime market, were effectively nationalised by the United States in September.
Banks, by virtue of their sheer size, often underpin national share indices, and the likes of the NASDAQ and the FTSE tumbled in the wake of bank losses. The Irish ISEQ index is a prime example: it stood at over 9000 at the beginning of 2007, and by October 17 had plunged to an 11-year low of 2643. When banks go down, they tend to bring much of the country’s stock exchange with them.
The free market economy recoils at uncertainty. Mortgage backed securities are still threaded through the complex distribution chains of the global financial network and nestled at the core of vast investment packages. It is near impossible to tell exactly which assets are sound and which are toxic. Who knows which firm will announce the next series of write-downs, who will be nationalised, or who will file for bankruptcy? In the atmosphere of doubt and insecurity that currently pervades the market it is no wonder that banks are uneasy about lending to one another. This has led to what is called the credit crunch. Unfortunately inter-bank lending is the industry’s main source of liquidity. The knock-on effect is that banks are reluctant to lend to lend to customers, stifling access to credit in the wider economy and turning what began as a financial crisis into a full-on economic downturn.
Keynes’ view was that either a weakening of the state of credit or a general lack of confidence can upset an economy. And investor confidence these days is thin on the ground while the credit situation is bleak. LIBOR rates (the rate at which banks lend to each other) have dropped in the past week following huge government liquidity injections, but they remain excessively high, reflecting an unwillingness on the part of banks to lend to one another. Retailers, too, are feeling the squeeze: October saw the biggest drop in US consumer confidence since records began in 1978. We will need to see a recovery in both of these indices before the good times return. Unfortunately at present judging when that might be seems no more than speculation.
