What caused the global credit crunch

what caused the global credit crunch

Smoking, the Credit Crunch and Global Warming

Tom Rand

Cigarette smoking, the credit crunch and global warming don't seem to have much in common. One is a habit of huddled figures on street corners and in doorways. Another is a financial mess so large it swallows banks weekly. The last is a confusing mix of rising oceans, fierce hurricanes and ice-free winters.

Scratch beneath the surface, though, and you'll find an alarming similarity.

Each provides something good in the short-term. Nicotine brings momentary pleasure, cheap credit maximizes profit and the hydrocarbons that are generating global warming have brought unprecedented economic growth.

But in each case the short-term good trumps catastrophic long-term effects. We are rational in the short-term, but irrational over the long.

A lifetime of smoking can cause a sudden medical crisis, a tumor. Years of gorging on cheap credit have brought a financial collapse stunning in its size and severity. Continued burning of fossil fuels will result in a worsening climate crisis, the severity of which is hinted at in recent hurricanes and droughts.

Even in the face of evidence that our path will end in tears, the decision to take action is deferred, again and again. Experts are ignored. The situation is not urgent enough to forego today's pleasure. Tomorrow will do.

Smoking, the credit crisis and global warming are all sudden death by incrementalism.

Borrowing itself is not a bad thing. Governments, companies and consumers do it all the time. But the credit fever that hit the financial system is not mere borrowing. It reflects a deeper and unsustainable commitment to short-term gain over long-term rational behaviour.

To really see how bad it has become look no further than credit swaps.

When a bank lends to another bank, it can lend out more than if it lends to a mining company. Banks are safer than other sorts of companies, so the lending bank needs fewer assets to cover the loans. If a bank lent to that mining company, they would often ‘swap' the credit by having another bank guarantee the loan. This is what brought down AIG, who played the role of guarantor.

On the books, it looks like they lent to a bank. That meant they could make more money by lending more money, hiding the risk and reducing the amount of capital they were required to hold.

It gets worse. The guarantor would sometimes be related to the lending bank, and it was often bank stock itself that was used to back the loan. This was called double gearing, referring to how a single pool of capital is used more than once as a covering asset.

Examples abound. Harris Bank lends capital for a Chicago development project. The loan is guaranteed by BMO. But BMO owns Harris, and some of the assets required of Harris were the equivalent of BMO stock.

It was all a house of cards ready to fall.

Everyone knew it couldn't last forever, but we all gambled that it might last just a little longer.

Then the housing bubble popped, as all bubbles do. Dropping housing values triggered a decline in the value of bank assets. Their stock prices fell, and the credit guarantees got called.

The experts saw this coming. Warren Buffet got out of the credit-swapping business years ago, calling them ‘financial weapons of mass destruction'. A new international banking agreement had been waiting in the wings since 2001, the New Basel Accord. It eliminates double gearing.

But listening to those experts was a downer. They were party-pooping intellectuals who just didn't know how to have fun.

The climate crisis will be just the same.

It's been twenty years since Margaret Thatcher announced to the UN General Assembly that climate change represented the greatest threat to civilization. Yet inaction defines our response to global warming. Tomorrow will do. Someone else will start first.

In climatic systems we find positive reinforcement, the equivalent of double gearing. Warming temperatures trigger events that increase temperatures even more. Ice melts in the arctic, and less heat reflects back into space. Permafrost melts and releases methane, itself a potent greenhouse gas. Oceans warm, releasing more carbon dioxide, just like a can of pop.

It is possible to flip the planet into a new equilibrium hostile to human life. If it happens, it will happen fast.

Still, the day to change behaviour never comes. We pretend the party can keep going. It cannot.

The credit crisis meant the whole world tried to de-leverage overnight. But it turns out our economy needs credit. Our panicked response led to a frozen banking system. We are experiencing a hard landing.

We can't de-carbon our economy overnight either. A defining event will eventually come - the mother of all hurricanes, an unending drought in the Prairies - but it will be too late. Our economy is more addicted to coal and oil than it is to cheap credit. That addiction will be harder to break.

Ignoring well known but long term effects of behaviour is to ignore reality. We learned our lesson from medicine and have legislated smoking to the margins. We will surely learn something from the credit crisis.

What remains to be seen is whether we learn a larger lesson. The transition to a low-carbon economy must start today.

Source: www.celsias.com

Category: Credit

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