Tuesday, September 23, 2008


Melting Down

The drama and spectacle of the past few weeks has been a little bit terrifying, but for a lot of people it will probably also prove slightly mystifying. Companies that few outside of the City/Wall Street have heard of are suddenly going bankrupt, and it’s the biggest threat to the global economy since the depression? Here’s my guide to what’s going on – although necessarily a bit rough and ready (I’m not much of a finance expert), hopefully it will help anyone with questions make sense of the crisis.

The past two weeks have been a nightmare. Are these all new developments, or has it been coming for a while?
The past couple of weeks have seen a serious escalation of the scale of the crisis, but the economic crisis itself has two immediate causes. The first, which dates back to last summer, is the popping of the bubble in the housing market, known as the “Sub-Prime Mortgage” sector. The second is the rise in global commodity prices, which has been happening for a while.

What are commodities, and why have their prices been rising?
Commodities are raw materials – essentially, the stuff that’s taken out of the ground which will be used to make other stuff. This includes production inputs like metals and minerals, and energy inputs like natural gas and oil. Prices have been going up for some time, but unlike previous price rises the main reason why they have been increasing this time is that demand for them is way up. Economic booms in Asia, especially China and India, along with other regions like Latin America and Eastern Europe, have meant that a whole load more people are suddenly buying stuff that they couldn’t previously afford, while booming economies in the rich world have pushed up demand there as well. Increases in supply haven’t been keeping pace, and as a result, their prices are rising. This is especially true for oil, which has been rising to record prices before falling back a bit more recently.

So that’s one side. What about the credit crunch?
The other cause of economic pain is the bust in the housing market, which has been spreading its consequences throughout the economy. This originated in the mortgage market. Essentially what’s happened is that low interest rates in many countries, including the US, UK and Spain, have led to lots of people being able to afford mortgages. Rising prices in housing encouraged people to get into the market, in the mistaken belief that house prices could only go up; the result was a classic “bubble” where assets like houses increased in price far above what they were actually worth, with demand being sustained almost entirely by people buying houses in order to get house price gains. In short, people were buying houses because their prices were going up, and the only reason that their prices were going up was because people were buying them. All that it would take to burst the bubble was for a crisis of confidence: as soon as people stopped buying houses, prices would stop going up, and then everyone would want to sell and prices would crash.

What precipitated this crash, then? Did something ‘prick’ the bubble?
Yes. The thing that pricked it was “Sub-prime” mortgages. These were a type of mortgage that were sold to people who wanted to buy a house, but had a bad credit history: either they had a history of defaulting on loans, or they didn’t earn enough to be able to pay the prices that houses cost in the current market. Normally, mortgage lenders shouldn’t give mortgages to such people, as there’s a chance they could lose all their money, but over the past few years these “sub-prime” borrowers were able to get mortgages anyway. Often the poorest and least-educated members of society, a lot of these borrowers didn’t realize that they were getting discount deals whose interest rates would increase dramatically a couple of years after signing on the dotted line; they then couldn’t afford their mortgage payments, and a whole load of mortgages went bad very quickly. This mostly started in the US, but something similar happened in Britain and other European countries as well. Suddenly a lot of mortgage companies were foreclosing (taking ownership of the houses of people who couldn’t pay their mortgages), and the housing bubble was pricked. Buyers’ confidence sunk, and prices started falling; as a result, even more mortgages went bad. Home owners who found themselves paying unexpectedly large mortgage payments that they couldn’t afford, on a mortgage that was suddenly worth more than the value of their house itself, decided to just walk away, and the housing market got stuck in a downward spiral.

Couldn’t the government do anything about the housing crisis before it spread to the rest of the economy?
Here’s the thing. Rising house prices have underpinned consumer demand (people’s willingness to spend their money on things, rather than saving it) as they’ve made people feel wealthier. When house prices started going down, overall demand for purchases in the economy as a whole started to drop. The usual way that central banks help out in a situation like this is by reducing interest rates – when interest rates are lower, you get less return on money that you save, so you’re more inclined to use that money to buy stuff instead; also, when interest rates are lower, things like mortgage payments are lower too, so you have more cash in the bank as well. But central banks couldn’t do that this time, because this effect of increasing demand also pushes up a really negative economic indicator: inflation, or rising prices. (When people buy more stuff without the supply of that stuff increasing, the price of the stuff will go up.) Because of the rise in raw material prices through more expensive commodities, inflation is already running higher than most central banks are comfortable with, and after the awful experiences of inflation in the 1970s and 1980s most central banks (like the Bank of England and the European Central Bank) are tasked with keeping inflation low rather than with keeping economic growth high. As a result, central banks couldn’t do anything to boost demand (like they did in 2001 during the Dot-Com bust) in fear that it would push inflation out of control.

But how did the crisis spread from the mortgage market to the wider financial sector?
It’s at this point that we identify another culprit for the crisis: the big investment banks (which in the US included the “Big Five” of Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns). These banks were partly responsible for the rise of sub-prime mortgage lending in the first place, through the innovative creation of new ways to package up debt. Each individual sub-prime mortgage was a pretty risky undertaking: the chances of the borrower defaulting on their mortgage were known to be really high. But if you took those mortgages and combined them with a different, safer sort of debt – for example, a corporate bond – then they became a lot less risky. A huge industry was created where banks and law firms could help place risky debt into a package with safe debt, and then sell those repackaged debts to lenders. Because the repackaged debts were thought to be much safer than their riskiest components, the interest rates that lenders got on the debts was low, so that purveyors of risky debts like sub-prime mortgages could raise the finance needed to make their loans really cheaply. They could still charge huge interest rates on the mortgages, though, and the gap between the interest rate on the money they borrowed and the interest rate they charged when lending it out to sub-prime borrowers was supposed to be enough that they could cope with the costs of the odd foreclosure and still make a profit.

It didn’t turn out that way.
No, it didn’t. What happened instead was that foreclosure rates were higher than expected, and as a result the financial companies who had been lending to sub-prime borrowers suddenly found themselves unable to repay the money that they owed to their own lenders. Companies and funds which had lent money to these lenders then found themselves looking at big losses. The problem was, because all of the packages of debt were so complex, suddenly it became really difficult for companies to figure out quite how high their losses were going to be. The complex deals that the investment banks had been arranging suddenly became a huge liability: rather than reducing risk by merging risky debts with safe ones, they had just reduced visibility of quite what lenders’ liabilities actually were. All the big banks had been lending money in the shape of these packages, and suddenly, last autumn, they all realized that they had no way of telling how much of it they were going to get back.

So what did they do?
They stopped lending money. The value of their assets was decreasing (as those packages, thought to be safe, were suddenly shown not to be, meaning that their value went down) and they had to put money on one side in case they needed it later once they’d unraveled all of their complex debts and figured out what their losses were going to be. As a result, the banks stopped lending to each other. The problem was that a lot of banks’ business models relied on having easy and cheap access to credit: companies like Northern Rock in the UK and Bear Stearns in the US needed to be able to borrow money from other banks cheaply and quickly in order to be able to pay off rolling debts, and when that money supply dried up – despite central banks stepping in to provide cheap lending to financial institutions – their entire business model was messed up. The banks that they usually borrow from, knowing that this could happen, realized that the risk of them not being able to pay back new loans was going up, and became even less likely to lend to them; in short, they suffered from a massive crisis of confidence. Northern Rock ended up being taken over the British government, and Bear Stearns was gobbled up by JP Morgan Chase.

How did we get from there to the last few weeks?
This was nearly a year ago now, and basically what’s happened is that things haven’t really improved since then. Commodity prices have stayed high, and investors have stayed nervous. The result is that banks and other investors have been nervously watching each other, ready to get out of any dodgy investments if any large institutions looked likely to fail. The US government stepped in to save Fannie Mae and Freddie Mac, which were big mortgage guarantee firms in the US who didn’t have enough reserves to cover the potential size of their losses; as those firms guaranteed much of the housing market, the entire US economy would have crashed dramatically had they failed. In the culture of nervousness, it was only a matter of time before another institution failed, and rumours started swirling about Lehman Brothers, the smallest of the remaining big investment banks. Those rumours were that Lehman didn’t have enough money reserves to meet its obligations, and was thus likely to collapse, and, of course, the very existence of those rumours meant that people wouldn’t lend money to them, further decreasing the size of their reserves and increasing the likelihood of their collapse. A couple of major knocks to Lehman’s performance – a Korean investment fund which they’d been hoping to get a big investment from walked away, and they then announced that they had made a massive loss in the last quarter – provided the spark that led to their dramatic collapse into bankruptcy as investors abandoned them.

The government stepped in to help save Bear Stearns, Northern Rock, Fannie Mae and Freddie Mac. Why not Lehman Brothers?
The reason for this is something in economic theory called moral hazard, which governments had been worrying about since the beginning. On the one hand, if a big institution fails then a lot of people will lose money, and that could have disastrous effects on the economy as a whole. On the other hand, if you step in to save any big institutions who look likely to fail, then you take away the fear of failure, meaning that such institutions will be more like to take bigger risks later, safe in the knowledge that if they fail they’ll be rescued. The US government needed to send a message that they couldn’t always been counted on to ride to the rescue, which is why they allowed Lehman to fail.

But that didn’t work out so well either.
No, again, it didn’t. The government misjudged it: the shock of the Lehman collapse, which was quick and dramatic, sent everyone on Wall Street running for cover. Merrill Lynch shares started to collapse spectacularly, and, amid worries that Merrill might soon go the same way as Lehman, they arranged a fire-sale to Bank of America, who bought them for a fraction of what they had been worth just a few months previously. Eyes next turned to American International Group, or AIG, which is the world’s biggest insurer. AIG had been heavily exposed to both the sub-prime mess and to Lehman Brothers debt: lots of people had taken out insurance with them against the possibility that Lehman might go bankrupt (this is fairly standard procedure in financial markets, but obviously Lehmans’ lengthy difficulties had exacerbated the problem). They thus found themselves on the hook for vast insurance payouts, and at the same time their own investment banking division was facing a write-down in the value of their own assets which meant that AIG would have to raise tens of billions of dollars at very short notice in order to stay solvent. They couldn’t possibly do it. AIG was much bigger than Lehman Brothers, and the shock of their collapse would have been even bigger: Lots of companies owned debt or insurance policies from AIG; their collapse would have meant that many companies in the wider economy would have had to write down the value of those assets, and the result could have been a string of retrenchments in the wider economy, and even some spectacular bankruptcies in sectors other than finance. It was a nightmare, so the government stepped in with $85bn of rescue money and took an ownership stake in the firm in exchange. The world’s largest insurer effectively got nationalized.

What happens next?
This is hard to say. The remaining investment banks may not be able to survive: they have already changed their status so as to take deposits from individuals, i.e. to become regular banks, and they may get snapped up pretty quickly – Morgan Stanley in particular is looking vulnerable. Of bigger concern to the economy, though, is the bad debts that plenty of banks have now accrued from all of these messes: loans that they have made which will never get paid back, and which will drag down otherwise healthy banks if they don’t get help with them. In order to restore confidence in the financial sector, the US government is proposing to create a public agency to buy those bad debts from banks so that the banks can move on and private investors can get back to business without worrying about their banks failing. This is currently stuck in Congress, but will probably become law fairly shortly. Unfortunately, the housing bubble is still ongoing, commodity prices are still high, and plenty of big companies will be incurring losses from their exposure to Lehman Brothers. This mess isn’t anywhere near over yet, and even if banking can be stabilized, we seem to be set for a pretty nasty recession in the developed world.

On the plus side, anyone looking to buy a house in the next twelve months is going to get a pretty sweet deal.

One last word of warning: this is all incredibly complicated, so if you spot anything I’ve gotten wrong, please go ahead and point it out.

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