The Credit Crunch - An Idiot's Guide

The Credit Crunch – an Idiot’s Guide

‘Britain will not return to the boom and bust of the past’ said Gordon Brown, then Chancellor of the Exchequer, in 1998. By mid 2007 confidence in the markets was at an all time high. The bull market had lasted a decade, observers believed it would never end. With so many financial institutions borrowing to the hilt to make more return, they were like a row of dominoes just waiting for a push.

The Sub-Prime Mortgage Crisis

Under successive US governments, controls over the domestic housing market had been lifted to encourage more low and middle income families to buy homes. Throughout the 90s the so-called ‘sub-prime’ market was targetted. Mortgages were cheap and plentiful.

All these loans had to be insured. That’s where the Federal National Mortgage Association (FNMA) came in, or Fanny Mae, as it was affectionately known. It’s primary purpose was to finance mortgage companies. Another company was created as a competitor, the Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac. These two Government Sponsored Enterprises (GSEs) were leaned on throughout the 1990s to support more mortgages. Fannie Mae started taking on ‘significantly higher risk’ as the New York Times reported in 1999.

In 2004 some anti-predatory lending rules were relaxed by the Clinton administration. Fanny Mae and Freddie Mac were still regulated by government, but other unregulated financial institutions, like investment banks, could now buy loan packages from mortgage providers, and sell them for profit. In order to do this they created bonds called Collateralised Debt Obligations (CDOs). The riskier loans were bundled together with safer low-risk loans and sold in ‘tranches’ which still boasted a triple A standard. As the sub-prime market grew in the US many of these CDOs were increasingly junk.

There was a sharp decline in underwriting standards among the private companies. They didn’t have to guarantee loans, they could just sell them on and wash their hands. Fannie Mae and Freddie Mac had to lower their own standards in order to compete in this unregulated market. They too began selling CDOs. These CDOs were awfully popular, and all over the world financial institutions loved them. Fannie and Freddie issued bonds to pension funds and global money markets, as did many other huge financial institutions.

Credit Default Swaps

There was yet a second layer to this market. In 1997 JP Morgan created a new financial instrument, Credit Default Swaps (CDSs). CDSs were insurance contracts that promised to protect the buyer from a high risk CDO. The seller assumed the risk, obligating him to pay in the event of a default, and the buyer paid a periodic protection fee for the duration of the contract.

Soon these swaps came to be seen in a speculative light, as derivatives. Investors with a positive view on a credit bond could sell the protection (CDS) and reap a profit. Investors with a negative view could buy the protection for a periodic fee and reap a reward if the bond defaulted; the rewards were written into the CDS contracts. These derivatives were, and still are, regularly traded, with values fluctuating according to the performance of stock markets.

CDSs were highly lucrative for international institutions like the American insurance company, AIG, risky hot potatoes with high returns. The impulse was to pass them on quickly. They were traded so frequently it was hard to see whether sellers could actually underwrite their obligations. When the music stopped many of them couldn’t.

The Domino Effect

In 2006 house prices started to decline and the first defaults began. As foreclosures spiralled out of control, Fannie Mae and Freddie Mac’s shares fell by 90%. In 2008 the US government bailed them out in a bid to restore confidence. Then they bailed out Bear Sterns, an investment bank, and AIG, both heavily exposed to the sub-prime market. Next to shake was the mighty Lehman Brothers, the second largest investment bank in America, but, the US government refused to help them. On 11th September 2008 Lehman Brothers filed for bankruptcy. It’s losses amounted to $619 billion, the biggest bankruptcy in history.

The Crash Goes Global

The repossessions, the fall of financial institutions, this was tragic, but it was an American problem. All through 2007 Mervyn King, then governor of the Bank of England, said it couldn’t possibly spread. The UK was ‘decoupled’ from America. It wasn’t until the collapse of Lehman Brothers that he started to worry.

In other parts of Europe they weren’t so confident. As early as 9 August 2007, a French bank, BNP Paribas announced they would no longer trade with any hedge fund that was heavily exposed to US mortgage-backed bonds.

The fall of Northern Rock

Faith in US bonds evaporated. Deceptive triple A ratings meant it was impossible to tell safe bonds from junk. European banks refused to forward any more credit. The media started calling it the ‘Credit Crunch’. All financial institutions were heavily leveraged during the boom years and could only operate on extended credit. There wasn’t enough cash in reserve.

The first UK casualty was Northern Rock Building Society. Its business model was based on borrowing money from financial institutions in return for bonds made up of mortgage loans sold in the UK. If it could no longer sell its bonds it couldn’t do business.

The Bank Of England stepped in to underwrite the building society, announcing its intention to the press. For 3 days there was a run on the bank as the populace took out all their savings, just in case. Northern Rock literally ran out of cash.

Fearing a run on all the other banks the Bank of England and the UK Government put together a bail out package of £500 billion for UK banks, temporarily buying a governing stake in both RBS and Lloyds. It has since sold back all its shares to both banks, but the cost to the tax payer has not been fully recouped. The figures, it says, can’t be calculated for some years yet.

Could it happen again?

Today the derivatives market has grown to vast proportions. CDSs are the most widely used type of derivative on the global market. Some say a crash couldn’t happen again, that banks keep larger cash reserves since the crash, diversify and hedge their investments.

Bear markets are inevitable and pundits say the downturn is due in about 2 years, but will there be a crash? Only if credit is over-leveraged during the final months of the bull market, only if confidence starts to exceed reality.

If it happens again faith in credit would be lost, and cash would be king, but the banks want to abolish cash. The interest rate, the tool which helps to stimulate spending and calm the markets, can’t be pushed down any further unless we go into negative interest, which is largely unknown territory.

Austerity and cuts to public spending have already pushed the poor close to breaking point and given rise to more extreme right wing politics throughout the US and Europe.

Despite this fragile environment, our chief political parties still believe in the ideology of the private sector run ‘free market’, despite the public sector having to rescue it in 2008. Today the Bank of England website tells us: ‘no one can prevent crises from ever taking place again.’

That’s not very reassuring.