Why did Northern Rock start to crumble?
Is the credit crunch a new kind of breakfast cereal?
And who blew the financial bubble?
Business sections are often the first part of the newspaper that goes in the recycling bin. There’s a good reason for this—most people find that the articles might as well be written in Klingon. What follows is for everyone who wants the world of high finance and the current shockwaves in the markets explained in rather more down-to-earth language.
Let’s start with Frank Capra’s 1946 movie It’s a Wonderful Life. You remember it, don’t you? Jimmy Stewart starred George Bailey, a small-town hero running a local bank known as a “Savings and Loan”.
In one of the key scenes, there’s a run on the bank on George’s wedding day. The customers queue up to withdraw their money, fearing that the Bailey Building and Loan Association is going under. George explains that one person’s deposit account had been loaned out as his neighbour’s mortgage, and offers them money from his own honeymoon fund to tide them over. The customers realize that the true safety of their money lies in the bonds of their community, the bank is saved and everyone thinks they finally understand mortgage finance.
A great number of people imagine that their own mortgage currently resides with their bank and hopefully has someone like Jimmy Stewart looking after it. In the USA, this was largely true until the the Savings and Loan (S&L) crisis in the 1980s caused many such banks to go under, unable to cover their debts. The S&L crisis—which the economist J. K. Galbraith called “the largest and costliest venture in public misfeasance, malfeasance and larceny of all time” — ultimately cost US taxpayers close to $150 billion. The current President’s uncle, Neil Bush, was Director of Silverado Savings and Loan, which alone lost $1.6 billion.
The problem started in the 1970s when, as a result of rocketing inflation, the S&Ls found themselves paying depositors higher rates than they could charge on fixed-rate mortgages—the only kind they could legally offer. This gradually eroded the solvency of the S&Ls. In a last-ditch attempt to save the system, they were deregulated. They then proceeded to enter new financial markets previously available only to the big banks. Crucially though, they were still exempt from the regulation that oversaw the larger banks, and so could undertake such business without scrutiny. Through a combination of fierce competition for money, reckless incompetence, greed and speculation, the entire S&L system was undermined, and a large number of S&Ls collapsed.
Enter Fannie Mae and Freddie Mac. They sound like Elmer Fudd’s cousins, but in fact, they’re two giant financial companies formed by the US government to help poor people get mortgages. Because of the vacuum left after the S&L crisis, they shortly owned or guaranteed 90% of the $1.4 trillion mortgage market in the USA. They achieved this largely by taking advantage of the fact that investors assume that, if such giant companies were to get into trouble, the US government will have to bail them out. Everyone gave them preferential rates on that basis, and they used these beat their competitors on mortgage deals.
Fannie and Freddie generally deal in what are called “prime” mortgages. These are mortgages where people of good credit put down a deposit of 20% or more and agree to pay a fixed rate of interest for 25 or 30 years. Those people supply proof of their income, which is duly checked, and a surveyor is sent out to confirm that the house is worth at least as much as the mortgage.
When a customer goes to a mortgage broker or a bank to get a mortgage, these checks are made, a deposit taken and a cheque written. The mortgage broker takes a fee and then immediately sells the mortgage to Fannie or Freddie, leaving him with the cash to make the next mortgage. The broker then receives further fees to handle the monthly payments and ensure these get to the eventual owner of the mortgage.
Once they’ve bought a few thousand mortgages, Fannie and Freddie package them up into asset-backed bonds known as “mortgage-backs”. These are then sold to investors on the basis that those investors will collect the interest, and if the interest isn’t paid—or the house is ever sold for less than the mortgage—Fannie and Freddie will make good the investors’ losses.
This left competitors to Fannie and Freddie looking for other ways to make money.
One way was to create mortgages for the folks that Fannie and Freddie wouldn’t touch because they couldn’t put down a 20% deposit, or because they’d defaulted on a credit card or car payment and had a poor credit rating. Mortgages for such people are called “subprime”.
The subprime mortgage companies used computer programmes to create “credit scores” for applicants that, so it was claimed, could distinguish between subprime borrowers who would dutifully pay their mortgages and those deadbeats who wouldn’t. The interest rates on the mortgages were graded in such a way that folks with lower credit scores paid higher interest rates. A basic rule of finance is: the more risky a deal, the higher the interest rate needed to persuade an investor to finance it.
The people looking for subprime mortgages were often relatively poor. What follows is a typical scenario.
A couple with one child—let’s call them Larry, Mo and Curly—have no savings but want to move on from renting an apartment to owning their own property. Their plan is to take a mortgage on a house for a couple of years and wait for house prices to rise, as they always have done in the USA since forever. Well, since the Great Depression of the 1930s, but to modern folks, that’s as near “forever” as makes no difference.
Larry and Mo hope the house will rise in value by at least 20% because they could then sell up and use that profit as the 20% deposit on their next house, obtaining a Fannie-approved prime mortgage at lower mortgage rates. They calculate that, even if something goes wrong and they’re made bankrupt, they still can’t lose because they’re starting from being effectively broke anyway.
The mortgage broker who provides their loan, we’ll call him James, acts just like Fannie and Freddie, converting these mortgages into mortgage-backs and selling them to the big investment banks on Wall Street. This brings in the money he needs to make new loans—and he gets a fee for every loan he makes. Unlike George Bailey, who had to watch out for bad loans because they’d undermine his bank, James will sell on the loan, so he isn’t at risk.
James has an incentive to make as many loans, and gain as many fees, as he humanly can, of course. Besides, he knows that, since house prices always rise, if things go bad, then the house will simply be sold to cover the loan. James also realizes that, if he doesn’t make a particular loan, the competition down the road will, and they’ll get the fee. James is ready to make a loan to anyone who can fog a mirror.
The Masters of the Universe on Wall Street then buy all these mortgage-backs based on subprime loans. They have a problem though: the folks they want to sell them to, the insurers, pension funds and hedge funds, can only buy investments that are rated “safe” by the ratings agencies. By definition, these subprime loans aren’t safe at all. This is where the financial engineers get to work and build a “derivative” called a collateralized debt obligation, or CDO.
To make a CDO, they might take a number of mortgage-backs and bunch them together. Then they slice up that bunch into “tranches”. They write a contract that says that, when a mortgage from the CDO defaults, the lowest tranche must take the hit. Only when the lowest tranche has taken a large number of losses do defaults start to affect the next tranche up and so on.
The lowest “equity” tranche, known affectionately in the business as “toxic waste”, might be 10% of the whole CDO, and this will be sold paying a high interest rate to compensate for the extra risk. The next “mezzanine” tranche could be of a similar size and will be sold with a slightly lower interest rate. The other 80% is therefore protected, unless there are a huge number of mortgage defaults, and these layers of protection get it rated “Safe” by the ratings companies. Once approved, it can be sold to the target market, earning a nice fat fee for the Wall Street bank. This conveniently provides the money to create another CDO.
There are three main ratings agencies: Fitch, Moody’s and Standard & Poor’s. Their job is to analyse various forms of investment and give them a rating based on how likely they are to default. The top, most sought-after rating
is AAA, which is equivalent to bonds from the sort of governments who aren’t likely to run off to Argentina the next morning. British and US government bonds are AAA, for example.
Large investors, such as pension funds, are often legally bound to buy investments at or above a particular minimum rating. Rather than analyse all the sundry investment possibilities themselves, they’ll instead just look at what the ratings agencies have stamped on the products. They only need to know the rating and the interest rate that the asset pays. The top tranches of many subprime-based CDOs receive AAA ratings, making
them supposedly as safe as government bonds.
What happens to the toxic waste tranches is more exotic. These are difficult to sell, of course, since their owners are volunteering to take a hit whenever a subprime mortgage anywhere in the whole CDO goes into default. For obvious reasons, the large Wall Street banks
would rather not keep these on their own books.
What they do is form their own hedge fund and put, say, a billion dollars into it. Then the hedge fund buys the toxic waste from the parent bank. House prices rise and the toxic waste becomes safer because, even if owners default, the house can be sold to pay off the mortgage, meaning no hit to the CDO.
A safer product rises in price and so the hedge fund is now showing profit, which can be advertised to attract investors. If global investors put in a billion dollars, then the hedge fund now has two billion dollars and change. The parent bank can then loan it $20 billion based on the collateral of whatever the hedge fund buys using the money. The fund now has $22 billion. It can use this to buy more toxic waste from the vaults of the bank.
This extra borrowing is known as “gearing” in financial circles. The way it works is very much the same as it does for a homebuyer. Let’s say you put down a 10% deposit on a house, get a 90% mortgage, and house prices then go up 20%. You now own 30% of the value of the house and have tripled your deposit money on what’s quite a small rise in the overall house price. Hedge funds use gearing in exactly the same way to multiply profits. The trouble is that gearing also works in reverse: if your house instead falls in value by 20%, then you own –10% of your house. You’ve lost all your deposit and you now owe more than your house is worth. It doesn’t work any differently for hedge funds playing with billions.
This is how the first hole appeared in the global credit bubble. In June this year, two hedge funds owned by Bear Stearns, a large investment bank, got into trouble. Their worried lenders, major Wall Street investment banks, grabbed the investments used as collateral and tried to sell them on the open market. This was highly unusual because these assets usually trade in-house and are values by mathematical models rather than by what they would fetch in open sale.The prices at auction started at 80% of that mathematical value and kept falling. This caused a panic because, if they sold at such values, everyone everywhere with similar products would have to “write them down” and reduce the net worth of their portfolio, possibly causing them to show losses. For hedge funds, that’s the sort of thing that makes investors unhappy enough to take out their cash, forcing more assets to be sold. And this creates a vicious circle that ends in the classic run on the bank.
Under pressure from the big players, the sale was quickly pulled and a bailout for the two hedge funds arranged. Within a month, though, one was declared “almost valueless” and the other so impaired that it refused investors access to their money. Warren Buffet, the world’s most successful investor, has called derivatives “weapons of mass financial destruction”.
Not unnaturally, people who had their money invested in derivatives began to wonder how safe their cash was. They looked to the ratings agencies, who were supposed to tell them, and discovered something unnerving: the ratings agencies were paid by the folks creating the CDOs to help them get the sorts of ratings they needed in order to sell them. They began to wonder if ratings agencies can be entirely fair and unbiased in such circumstances. After the Bear Stearns episode, there were clearly grounds for worry that CDO ratings might not be all they were cracked up to be. The ratigns agencies then stated that they only rated the chances of assets going into default, not the chances of them falling in price… This wasn’t what investors wanted to hear.
Warren Buffet, the world’s most successful investor, has called derivatives ‘weapons of mass financial destruction’.
At this point, many people began to suspect that their investments weren’t in good hands and they began to retrieve them. Hedge funds around the world then had to sell assets to pay investors who wanted out. And when there’s a lot of selling of something, that something tends to fall in price. This made lenders to hedge funds worried and try to call in their loans. Many hedge funds realized they were in trouble and cancelled the right of their investors to redeem their cash until the fund could be liquidated. Many such investors are already looking at double-digit percentage losses.
It goes without saying that there aren’t many people looking to buy CDOs right now. This means that the Masters of the Universe on Wall Street will be denied the giant fees they get for this work. Indeed, several banks have had to write off multiple billions of dollars that have been lost in the market turoil of recent weeks. Brokers are looking at greatly reduced Christmas bonuses and the certainty that many of their number will soon be looking for other work.
No demand for CDOs means that nobody needs to buy the subprime mortgage-backs required to create them. This in turn means that folks like James, our original mortgage broker, can’t sell mortgages to get money to make more mortgages. And this means that he can’t earn the fees that he needs to pay his own mortgage.
Worse, it turns out that a clause in many mortgage-backs says that, if the mortgage defaults in the first six months, the onus is on the original broker to make good the investor. Some homebuyers renege by their second monthly payment, and they’re required to make the first one when they sign the mortgage forms. James now has no money coming in and investors are chasing him for recompense for the delinquent mortgages he originated. He’s going bankrupt, but he’s not alone—there are a lot of others just like him.
In the USA, more than 150 national mortgage brokers have gone under since the Bear Stearns episode, with the largest broker, Countrywide, struggling to survive by using its entire $11.5 billion credit line and laying off one-fifth of its 55,000 staff.
Of course, this makes it very much harder to get a subprime mortgage. Those who can still obtain them will pay interest rates closer to 11.5% than the 8.5% they’d have obtained in May. This is because the risk of making subprime loans has risen and the investors require higher rates to compensate them for the extra risk.
Trying to help, the US Central Bank cut the American interest rate by 0.5% in September and another 0.25% in October. The bondholders, however, concluded that this might lead to higher US inflation and promptly raised the mortgage rate to compensate themselves for that risk too. In the days of Jimmy Stewart, the Central Bank controlled mortgage rates. Now it’s international investors who call the shots.
This means trouble for our homebuyers, Larry and Mo. They got a mortgage at a “teaser rate” of 4% for two years. The 4% wasn’t enough to pay even all of the interest, and the rest has been added to the capital owed. When their two years are up, they’ll move to that 11.5% rate and they’ll also start paying capital. This means they could ultimately see their monthly payments triple when they can barely afford to pay the teaser rate right now. Their plan to sell and raise the 20% deposit on another house is in tatters because house prices haven’t risen in the USA for the past two years, and now they’re going down…
They can’t even quit the house because the sale price would be lower than the mortgage as a result of the two-year period when the missing interest got added to their loan. Then there’s the several thousand dollars they’d need to pay off the various fees involved in selling. Most likely, Larry and Mo will, over a period of a year or so, see their house foreclosed (repossessed) as they fall behind with the mortgage. The house will then be sold for less than the mortgage and they’ll be looking for somewhere to rent while still owing some money. Their defaulted mortgage also means that a toxic waste CDO will take another hit, adding to the credit crunch.
The good news for Larry and Mo is that the rest of the debt will probably be written off. The bad news is that this is seen as income by the taxman and they’ll owe an immediate payment of the taxes on what’s written off. The US government is currently trying to change this situation.
According to Realty Trac: “Based on the rate of foreclosure activity in the first half of 2007, we could easily surpass 2 million foreclosure filings by the end of the year.” This is also likely to increase in the next year as more and more subprime mortgages reach their two-year resets. Each foreclosure is another property heaped onto a market already in a glut.
There is currently over ten months’ supply of housing for sale in the USA according to statistics from the National Association of Realtors. Every house foreclosed represents another family who can’t buy a house, a family whose credit rating is now so bad that they probably never will.
The omens suggest that house prices will fall even further. CBS Television described US housing markets as the worst “since the Great Depression”, and any further fall will mean more mortgages in trouble and another turn of the screw for CDOs.
Even the supposedly safe AAA tranches of CDOs are taking hits. As of the start of November, some had fallen in value by 20%. The toxic waste and mezzanine tranches are sometimes nearly worthless. Worse, the carnage is spreading outside subprime mortgages. “Alt-A” mortgages, which lie between prime and subprime, are in almost as much trouble. “Jumbo” mortgages, made for people buying houses too large to be insured by Freddie and Fannie, are seeing more and more defaults. There are even some prime mortgages going into default. This means that Freddie and Fannie are being called upon to make good investor losses on the mortgages that they guarantee.
Given that they insure mortgages worth $1.4 trillion between them, while owning capital of around 3% of that total, it’s possible that they themselves could run into trouble if US housing markets continue to get worse. The US Central Bank says that there is no guarantee of a taxpayer bailout, but if this did happen, there would be almost nothing left of US mortgage markets.
It’s difficult to imagine what would happen to US housing if almost nobody could obtain a mortgage. In 2005, Alan Greenspan, then head of the US Federal Reserve, said that he saw no bubble in the US housing market. In September 2007, however, now retired, he described the markets in mortgage-backed derivatives as “a Savings and Loans disaster waiting to happen”.
As the debt from mortgages spread to banks and hedge funds around the world, this meant that the problems caused by their collapse affected economies everywhere. Germany’s Deutsche Bank wrote off €1.5 billion in losses in October and required help from the government.
In the UK, Northern Rock saw a run on the bank as depositors queued to withdraw an estimated £2 billion. The government panicked and offered a guarantee to depositors and massive loans to the bank. By the start of November, Northern Rock had borrowed £20 billion and expected to need more.
Merrill Lynch, a large investment bank, lost $9 billion on subprime loans, forcing its chief executive to resign. Bank of America lost $4 billion and has already announced 3000 job losses in its investment division.
Even UBS, the Swiss bank, lost $3.6 billion. All around the world, banks have declared huge losses on CDOs and related derivatives called structured investment vehicles, or SIVs.
As the credit bubble went global, it created debt to feed housing bubbles in Britain, Ireland, Northern Ireland, France, Spain, Belgium, Holland, Italy, Australia and New Zealand. Currently, the bubble has already burst in Ireland, Spain and France, and is bursting in Northern Ireland Australia and New Zealand.
So far, all the talk is of the “US subprime bust”. There’s no doubt, however, that the credit bubble itself was global and it may be that US subprime is simply where the first leak appeared. These problems are not unique to the US and it remains to be seen where the next holes will appear.
The housing bubble led homeowners in many countries to remortgage their homes to pay off their credit card debts. Now that house prices no longer rise, this means of robbing Peter to pay Paul is no longer possible. However, in the USA and Britain, homeowners have now begun to use credit card borrowing to pay their mortgages. Given that credit card interest rates are much higher than mortgage rates, this quite clearly isn’t a long-
The credit card companies also sell on credit card debt and it’s repackaged into CDOs in precisely the way that mortgages were. Banks, unable to sell mortgages, have begun mailshot campaigns to put more credit cards into the hands of these eager borrowers. It remains to be seen whether this remake will have a different ending.
Other countries are watching the US housing crisis with horror—and wondering nervously about their own recent rises in house prices. Many reassure themselves that they’re not like the USA because they have less room to build or because their citizens save more.
Legendary investor Sir John Templeton said that the four most dangerous words are “it’s different this time”. Sadly, history shows that each time these words are uttered, it turns out that what seemed to be an economic miracle was yet again a bubble fed by a seemingly insatiable appetite for debt. The International Monetary Fund recently said that the UK housing bubble looks even more overvalued than the US one, and that the world risks a “severe global downturn” as a result of the credit crunch.
When credit bubbles burst, the primary asset, this time housing, tends to fall in value by between 50% and 90%. Japan began its own descent into the bust in 1989, and despite interest rates at zero, low unemployment, little room to build and a population of inveterate savers, it has fallen well into that range of price drops in both shares and housing.
The technology stock bubble that bust in 2000 saw falls of around 80%. The Wall Street Crash in the 1930s saw stocks fall by 89%. The South Seas and Mississippi bubbles, the Canal Stocks and Railroad bubbles, and the Tulip Bubble itself all savaged their investors with falls of such magnitude. It appears that every third generation must relearn the lesson that debt makes a treacherous friend.
When Satyajit Das, an expert of 30 years who designed many modern derivatives, was asked whether the credit crunch was now in its third inning, he laughed and said: “We’re actually still in the middle of the national anthem in a game destined to go into extra innings.”
Mike Holmes is an economic contrarian who frequently commentates online under his nom de guerre, A Friend of Fernando Poo. He doesn’t have a mortgage.