by Bill Robinson Sep 21, 2008 at 00:01Ever since the sub-prime crisis started to make headlines last August, people have been asking if the troubles in financial markets will lead to a wider economic downturn. It seems increasingly likely because:
The three major international World Bank forecasting organisations have revised their world economic growth projections sharply downwards over the past year.
All of them now expect slower global growth in 2008 than in 2007.
The European Commission is forecasting a deceleration in EU growth from 2.8% in 2007 to 2.0% in 2008, falling again to 1.8% in 2009. The forecasts for 2008 and 2009 are both 0.5% lower than six months ago.
In Europe it is clear that output growth started to slow last year, and the confidence indicators, which have historically been strongly correlated with output, show that the downturn has continued this year. In the UK HM Treasury’s monthly survey of independent forecasts shows expected GDP growth of 1.6% in 2008 falling to 1.3% next year. It is becoming increasingly clear that even if the downturn is not (yet) a steep one, it is going to be protracted.
Behind the market crisis
How did the crisis in financial markets happen and what are the transmission mechanisms by which it is affecting the real economy?
It is often asserted that this crisis had its origins in the US housing market. That is the truth but not the whole truth. The true origins of the crisis lie in a global surplus of savings. The most famous symptom is China’s large current account surplus.This represents the net savings of the Chinese nation, which has been consistently used to buy US government bonds. The oil exporting countries run similar surpluses, which have grown as the oil price has risen, and are also large purchasers of bonds.
The resulting strong demand for bonds has driven up their price and driven down real yields to extraordinarily low levels. The resulting availability of cheap credit fuelled the long boom since 2000 and had a particularly strong impact on the housing market.
Financial institutions, looking for ways of improving yields, hit on the ideas of:
1. extending house purchase loans to less creditworthy people and charging them more;
2. packaging up those mortgages, along with more conventional mortgages, into special investment vehicles (SIVs); and
3. selling titles to the income from those vehicles to different classes of investor under different terms and conditions at different rates of return.
The basic ideas behind this strategy were: the extra income from the sub-primes would spice up the total return; and by varying the proportion of higher risk mortgages in the mix, it was possible to create a range of instruments with different credit ratings and different returns.
Accident waiting to happen
The strategy was a huge success. Investors loved the SIVs, which encouraged the banks to extend their lending to sub-primes. But this was only one of many ways in which, over the course of the cycle, lenders were prepared to give borrowers home loans representing ever greater proportions of their income. With more money chasing the same stock of houses, prices inevitably rose, thus apparently providing good collateral for those loans and making the lenders even more willing to lend. The US housing market thus became an accident waiting to happen.
The gamble underpinning the aggressive lending strategy was that it would not matter too much if the sub-prime borrowers defaulted because their homes could always be sold off. That gamble failed, not because the borrowers defaulted but because house prices were driven to unrealistic levels from which they have now started to fall. As soon as house prices turned downwards, the repossessed homes did not generate enough to pay the bond holders.
At first the only people who suffered were those with an equity stake in the SIVs. But as the crisis deepened and an ever high proportion of mortgages became non-performing, the losses spread to the higher tranches until even the most senior A-rated debt was affected.
What is not yet clear is the extent of the collateral damage. As the housing market has fallen, it has become clear that the true value of mortgage-backed securities is less than their face value. The problem has been that these securities have been sold off to a wide variety of investors all around the world. Everybody knows there are big losses out there. Nobody quite knows where they lie. So the banks have become mistrustful. Where they were once excessively willing to lend, they have become remarkably cautious.
A great deal of economic activity depends on credit. Companies rely on credit to facilitate deals and to finance real investment. Consumers rely on credit for large purchases – house purchase and refurbishment, new cars, holidays, consumer durables. If credit is withdrawn or becomes more expensive, companies will abandon mergers and acquisitions activity and shelve investment plans. Consumers will defer spending on big ticket items – especially perhaps moving house.
Much consumer spending is associated with housing transactions. Those who move typically unlock some of the equity tied up in their houses and spend it – on agents’ fees, redecoration, new carpets, furniture, white goods. As house prices reach a plateau, transactions will stall and spending of this sort will be sharply reduced.
The events of last summer and autumn clearly drove up the price of credit – commercial lending and borrowing rates increased relative to the official rates. As worries about recession risk grew, the authorities reacted by cutting official interest rates. The jury is still out on whether they have done enough to stave off recession. Market interest rates remain significantly higher than official rates and there are some signs of a downturn in the real economy, although it is still too early to be sure. In January the stock markets took fright and they remain depressed today.
As a result of the credit crisis, many organisations have already suffered huge losses. Some of them will look to recoup some of those losses by suing those they hold responsible. If it becomes clear that the boom and bust in the US housing market is at the root of many troubles, questions will be asked about the lending policies that led to a rise in US house prices from just over three times income in 2000 to more than six times by 2006. Was it the fault of the bankers, for making the loans? Of the regulators for failing to stop them? Or
of the ratings agencies for continuing to give mortgage-backed SIVs an A rating?
These questions are starting to be asked, and not just in the US. Similar issues arise in the UK market, where losses may prove particularly severe for borrowers in the buy-to-let market. As the downturn spreads from the financial markets to the real economy and more businesses find themselves in difficulty, some of these questions may be tested in the courts.
Recessions are, by definition, a time when business activity slackens. But for commercial litigators they can often be a particularly busy time. The signs are that this downturn may be characterised by a lot of litigation arising out of the credit crunch and its causes.
Bill Robinson is head of economics at KPMG Forensic and a former special adviser to the Chancellor of the Exchequer.
This article was first published in KPMG’s Forensic Accountant, issue 32, 2008.
Thank you for ac lear and logical exposition of the problem, Bill Robinson. At last some one who knows what he is talking about. A rare event in the British press.
15:32 on 21 September 2008
of course when times are good solisitors prosper, but when times are bad they get even fatter.
It's just a pity it will not be those irresponcible and frightened so called leaders of the world economies who decided to slash interest rates in March 2002 that will fill the docks, those prats also told us that Sadame could bomd London in 45 mins or some such rubish.
It would be nice to see them dangle. (sorry about the spelling)
19:18 on 21 September 2008
And if Gordon Brown had included food, shelter and warmth costs in the formula he gave to the Bank of England, to work out the inflation rate, perhaps the BoE would have 'seen' the rising inflation.
Instead he excluded the shelter (housing) costs from this formula.
Consequently, the BoE did not raise rates when inflation took off in Council Tax and mortgage costs.
19:51 on 21 September 2008
Those of you who can afford it should put as much into a SIPP (self administered pension scheme) as possible.
Firstly,this bankrupt government will soak the middle/better off classes with increased taxes to pay for so called "full employment" in the public sector.You know who I mean,those who clock watch at 9,move a bit of paper about,yawn and leave at 5.
How? Eliminate higher rate tax relief on pension contributions.
Why a SIPP? Well,you can control your own investment strategy.I am quite capable of losing my own money without letting some A/H of a fund manager to do it for me.
09:02 on 22 September 2008
I agree the article is getting near the reasons behind the credit issues. However a few extra details. The SIVS are not all backed by residential mortgages,they include - credit card debts,car loans,commercial property loans and student debts. These are much riskier that RM as homeowners particularly in the UK tend to pay their mortgage first.
Second while it would be nice to blame the Chinese etc. It is the banks that have geared themselves up and sold SIVs etc to unsuuspecting Pension schemes and Insurance companies who thought they were getting an extra 25 basis points on a AAA rated piece of paper that was tradeable and not illiquid.
The banks are not going to get the punters to take their dodgy loans in the future. Credit is going to be very scarce and expensive.
13:58 on 22 September 2008
Mark Hudson - Capital Markets specialist, SAS:
The credit crunch hinged on one element. Risk. Nobody knew, accurately enough and with enough confidence, who had the risk and how much.
For years, bankers and their IT departments had been struggling towards the holy grail of Enterprise Risk Management. It sounds complicated but the idea is very simple - Traders assume risk to make profit. It's the name of the trading game. The problem is, traders are specialists. They assume risk in ways that are obscure to anybody else, and complex even to the traders themselves.
The best traders are experts in managing their own narrow risks. The problem starts when these risks interact. The lack of confidence in the pricing of securities based on US mortgages gave rise to the sub-prime crisis. Pricing and risk are almost two sides of the same coin. The sub-prime crisis in turn put liquidity pressure on the likes of Bear Stearns, Lehman and HBOS, not to mention Northern Rock.
The best remedy? For the senior management of a bank to know every risk on the books, and where it lies, at an aggregate level, up to date at least every day. That is ERM. Simple.
What's not simple is how to get it done. IT systems get driven by narrow requirements from those specialist traders anxious to make profits by moving fast. Stitching everything together later to make that "Enterprise view of risk" is hard. Banks always knew this was important. During the week of 15th September, it became clear that ERM is the radar the banking industry didn't have. And the missiles were inbound all week. They had left achieving ERM too late for this crisis. Such was the pain, not least in board rooms, that those who remain, or the successors of those who walked the plank, will not forget this time.
Expect to see a lot more focus on building ERM radar defences as banks strive not to be the Lehman or HBOS of the next Black Week in Banking.
11:13 on 30 September 2008
cum on maan at least giv a lil bit more clear information about hu iz 2 blame for the credit crunch and y did it hapen 4.
i need 2 find ouit quikly because i need 2 du ma corsework on dis.
but bill robinson i understand what you mean and am glad dat u understand all dis stuff unlike sum ppl.
10:13 on 25 November 2009
muy bueno este articulo porque muestra como fue la crisis y que fue lo que la irigino y muchos aspectos economicos que influyeron en el 2008
Asi mismo nos encontramos con puntos y estrategias financieras que van a ser muy importantes para el fututro de la economia
23:17 on 11 March 2010
I think this is a very good essay about the economical crisis in 2008.
There is a lot of comments to concern this problem and have as well strategies