How it happened

In a post earlier this week I referred to "a few badly-sold mortgages in the US [that] set off an international banking crisis". In the comments underneath that post, two readers asked me to explain how this happened. So here goes (though of course it's a lot more complex than this in reality).

1. There has in the past decade been an abundance of global capital, stemming particularly from the rapid growth of China and an Asian savings glut.

2. Given this savings glut, and the effect of Chinese imports in restraining inflation in the Western economies, interest rates were kept below market clearing rates. A further and understandable reason that interest rates were kept low was to support the economy after the shock of 9/11.

3. Investors therefore sought high-yielding securities in order to boost their rates of return. This "search for yield" caused credit spreads (i.e. the difference in yields between government bonds and corporate bonds) to decline to historically low levels, and encouraged the use of leverage. (And to explain that point: the yield on a government bond is considered to be "risk-free", because the government won't go bust - it can always print money. The yield on a corporate bond will be higher, to reflect its greater risk.)

4. The search for higher-yielding investments also stimulated a market for asset-backed securities, where the assets in question were US mortgage loans. As is well known, mortgages had been aggressively marketed in the US to low-income borrowers who were less creditworthy - and this is where it all went wrong.

5. Investment banks packaged up these mortgage loans together, sliced them and created marketable securities out of them (this is known as securitisation). The securities were then sold off to investors in the money markets. The investors believed these loans to be safe, because the lenders Fannie Mae and Freddie Mac were quasi-government agencies.

6. Securitisation is a good thing in principle, both because it turns illiquid assets into tradable instruments and it allows credit risk to be spread. If you think this is a cruel joke on my part, given what has happened recently, consider the effect that the collapse of Enron a few years ago had on the market. The market absorbed the shock easily, and part of the reason was an active market in credit derivatives. It enabled banks to insure against the risk that their loans to corporate clients would go bad. And the banks' exposure was parcelled out to investors across the financial system.

7. But it hasn't worked that way this time. Lenders were reckless, and approved mortgages that were a tremendous risk. In the case of many mortgage approvals, borrowers didn't have to prove their income and so lied about it. They were encouraged in this behaviour by the widespread and entirely erroneous assumption that house prices are a one-way bet.

8. Ratings agencies, whose job it is to assess the credit quality of securitised debt, gave these securities much higher ratings than they merited. Their models were misleading, and this factor as well as the high degree of leverage has created huge losses. Even worse than the misrepresentation of the quality of these securities was the banks' behaviour in creating off-balance sheet funds, which they then stuffed with this highly dubious debt and sold on to investors.

9. Securitisation is supposed to spread credit risk more widely, and thereby reduce any single investor's exposure. In the case of the subprime mortgage disaster, it has acted more like a contagion. The banking model of originating debt and then distributing it has brought the Western financial system to this crisis. In particular, the wholesale lending market has frozen up. Banks will lend to each other only at punitive rates of interest, for fear that they won't get their money back.

10. The only course in the circumstances is to recapitalise the banks so that they are able to lend again. This is what governments are attempting to do. There are many disputes about the best way of doing it. In my opinion, but not that of others, the British Government has done the right thing in recapitalising the banks in return for ordinary shares. That model is the least bad approach yet devised for government action in other countries.

Incidentally, I disagree with my colleague Daniel Finkelstein that "the credit crunch has demonstrated ... that the laws of free markets are iron ones". It's true that regulators, governments and central banks have failed, but the credit crunch is born of excessive leverage, which in turn reflected a belief that new financial instruments had reduced borrowing risks. And these developments have been driven by the financial sector. One of the greatest failings of the banks is that the incentives to fuel the asset price bubble, as against the penalties for getting it wrong, were perverse. Top banking executives never carried the full risks, because in the event of failure they could count on generous compensation packages to cushion the blow. (As I argued in the newspaper this week, there is not really a "market" in the pay of top bankers at all, because compensation has been typically set by committee.)

Heaven knows, we can all agree that centrally planned economies have proved a ghastly failure. But the lesson of the credit crunch is not the one Daniel infers. It is rather that financial crises will happen regardless of whether we have a limited state or an expansive one, and we have to make policy in that knowledge.

Comments

[ortega]

It's a pleasure to read you when you forget about Chomsky, Galloway, Palin et al.

[Bruno Caldas]

The lessons that you and Daniel take from the crisis diverge seriously and to try to answer, the main question is:
Can we really separate the damages that lack and excess of regulation caused?
Not really. no one can say for sure that lack of regulation caused such crisis, because there are lots of rules, regulations and obligations that banks have to follow.
And no one can say that excess of regulation has caused it, because there were some unregulated aspects of banking.

Im pretty sure lending, specially subprime, isnt laissez-faire. There are rules and cans and cants.

Instead of trying to guess, why not see what the most accepted theory so far says?

And that would be... "Markets clear"

[Chris]

> the British Government has done the right thing in recapitalising the banks in return for ordinary shares

But they're not ordinary shares, they're preference shares, and I read today that banks will pay no dividends to me (a tiny HBOS holding) or, more seriously, to pension funds, for five years.And coming shortly, minuscule interest rates on my cash savings to boot. Thanks, Gordon.

Interesting that you blame the trouble on (inter allia) the granting of mortgages to borrowers who were terrible risks, but have said elsewhere that it's not the Clinton administration's fault for passing a law that required lenders to do just that. I think your politics are getting in the way of analysis there.

[Alcuin]

Thank you for that, Mr Kamm. If I may offer a few thoughts from an economic neophyte and an engineer.

1 Now that governments are involved, there is no further safety net. Certainly governments can print money, but that can lead to Zimbabwe, and I hear that some countries in the Eurozone may be a bit shaky.

2 How will this affect the plans that a possible President Obama has for alleviating poverty, particularly in housing, and will congressional oversight be sufficient to restrain his socialist tendencies?

3 A BBC pundit noted that the stock market has moved beyond the banking crisis. It is as though your car just blew a head gasket and you asked the garage to fix it, give it a brief once over and they found rust. The stock markets seem to have found rust, and that is why they continue to plunge.

4 Economic troubles will exacerbate other political stresses, notably in health, education, defence, policing and social cohesion. I have a bad feeling about the last. Not only has Labour's economic policy unravelled spectacularly, but the other stresses they casually dismissed will now move up the agenda. I wish I thought the Cameroons had the answer.

5 Four Labour administrations this century, each ending in economic chaos.Two Dem administrations at the root of this current mess (admittedly with a Rep ne asleep at the wheeel). Yet the Liberal elite still believe that hope will triumph over experience in their adulation of the "black Kennedy" across the pond. Yet Kennedy had ties to very shady people, almost - through ineptitude - started WW3, got into Vietnam with no exit strategy, and could not get his proposals through Congress. Why are you still a Liberal?

[Oliver Kamm]

Chris, thank you for that: strictly it's a combination of prefs and ordinary shares. As I understand it, the Government (or rather, the taxpayer) will buy £5bn of prefs in RBS, plus £15bn of ordinary shares assuming the bank can't raise the money from existing shareholders. The government will also buy £8.5bn of HBOS ordinary shares plus $3bn in prefs.

On the issue of dividends, you'll note that there's been some compromise on that issue. I have to say that I would favour a suspension of dividend payments, which would only work if it was indeed mandated across the banks in which the govt takes a stake. Normally, if a company fails to pay a dividend, then the market takes that as a sign of future problems and therefore revises down its earnings estimates - with the result that the stock prices falls. If the banks couldn't pay dividends because they were not allowed to, then the market would not immediately interpret this as a sign of future problems, and it would be a smoother process to recapitalise the banks.

I sympathise that your bank shareholdings aren't proving a good investment at the moment. But as you will well understand, there is no contractual guarantee of a dividend payment when you buy a company's shares. And in the meantime, it's essential for the economy, the corporate sector and the banks themselves that they get recapitalised.

[Chris]

Thanks for responding. I do indeed understand that 'the value of investments can go down as well as even further down,' and I do agree about the need for recapitalisation. I hope you will not therefore expect me to shake Gordon Brown's hand and tell him he's doing a grand job getting us out of the disaster he played a significant part in getting us into.

And PS, what Alcuin said.

[William]

It's really all about step 4, and the later statement "Lenders were reckless, and approved mortgages that were a tremendous risk."

But why did they approve them, if they were a risk? Didn't they appreciate the risk - no, a lot of the mortgages were obviously insane. They approved them because their pay was linked to approving them. As it's always easier to sell things than to make a profit on them, banker's pay became oriented towards sales rather than profit. Easy to do if it's other people's money you're playing with.

In the internet bubble, many startups were valued in the same way - by volume rather than profit - so we've seen this scam before.

[Dom]

"But why did they approve them, if they were a risk?"

I'm still unsure about the part the CRA (under Carter and modified by Clinton) played on this point. Groups like ACORN were always demanding more of this risky loans.

[jono]

"Normally, if a company fails to pay a dividend, then the market takes that as a sign of future problems and therefore revises down its earnings estimates - with the result that the stock prices falls. If the banks couldn't pay dividends because they were not allowed to, then the market would not immediately interpret this as a sign of future problems, and it would be a smoother process to recapitalise the banks."

That is really rather strange logic. The govt is going to create a problem but, because its the fault of the govt, the market will ignore the problem? In any case, shares with no short to medium term yield will lose value regardless of why that is the case.

[Tony Francis]

It would appear hedge funds in their attempt to increase returns have been largely unsuccessful. From 1994- 2006, hedge funds in the aggregate returned annualized 10.8% while the S & P 500 returned 10.3%. So all the volatility, risk and large fees was worth 0.5% over that time.
http://www.cxoadvisory.com/blog/external/blog2-13-07/

Of course, one can draw graphs which make it look better:
http://seekingalpha.com/article/67847-hedge-fund-index-performance-vs-the-s-p-500

1/2 percent is not insignificant. But it may not be worth it to the individual investor considering the volatility, and unreliability of any given hedge fund.

[mark mcfarland]

Dear Oliver, Congratulations on a very succinct and informative piece.

You missed two points though. First, proprietary trading desks in many of the international investment banks were oblivious to risk managers, much like during the emerging markets debt crises of the 1990s. UBS has admitted so. Had risk-weighted trading been properly implemented, the mess would probably never have gotten this bad.

Second, the chaos created by the ad hoc strategy(ies) of Paulson and Bernanke induced panic that worsened the crisis - through a combination of cash hoarding and blanket selling The ill-thought out failure of Lehmans left hedge funds frozen out of Prime Broker accounts and facing massive redemptions. In all, B&P have a lot to answer for.

Like you, I tend to agree that the UK's recapitalisation plan is the best so far - although it is borrowed from the highly successful Swedish model of 1992 - but I hold deep reservations that the quid pro quo of continued lending will eventually lead to a much greater and longer slump than the general public in Europe is expecting.

[Peter T]

Oliver,

Thanks for the explanation.

Peter

[Jack]

If interest rates were really below market clearing rates there would have been an acceleration in the rate of consumer price inflation, as happened in the UK in 1990. The "savings glut" was part of the supply of capital and low interest rates were required to ensure that the market did clear and these savings were lent to borrowers. The problem was not the expansion of credit, but, as you say, extending credit to people unable to honour their debts.