FINANCE: by Patrick J. ByrneNews Weekly
Sub-prime mortgage crisis paralyses credit system
, February 2, 2008
The current global financial crisis is different from most previous ones, and the consequences may be with us for years to come, reports Patrick J. Byrne.The sub-prime mortgage market crisis has hit a vital nerve in the international financial markets. It has spread from the banking sector to the stock markets, which have suffered their longest straight decline in 25 years, making a US recession more likely.
In the period of rapid globalisation of world financial markets, other financial crises have been restricted to stock and currency markets - Black Monday 1987, the Mexican peso crisis of 1994, the Russian debt debacle, the Asia economic meltdown of 1997, the Long-Term Capital Management collapse of 1998 and the bursting of the dot.com bubble in 2000. These crises were relatively transparent. Reserve banks around the world cut interest rates and injected funds to restore confidence and growth to the markets.Property deflation
One exception was the Japanese property collapse in the late '80s, which spread to the banking sector and slashed economic growth for over a decade. Even after interest rates dropped to near zero, property deflation has continued through to today. Property declined 32 per cent over the past decade.
The sub-prime collapse is different from other financial crises. It has sent a seismic shock through the financial system and bears parallels with the Japanese experience.
About its spreading to the banking sector (and now the stock market), The Economist
magazine (December 22, 2007) notes: "The grievous experience of the past two centuries of financial busts is that when the banking system is in difficulties the mess spreads. Straitened banks lend less, sucking money out of the economy. In rich countries that threatens to tie down companies and give ailing housing markets a kicking. The data barely show it yet, but the financial malaise could yet be aggravated by a broader economic malaise."
The crisis has been the product of loose monetary policy, which led to rash lending, particularly in the US, and securitisation of mortgages. The globalised financial markets have seen the crisis spread rapidly to European markets.
In countering the bursting of the dot.com bubble, the US Federal Reserve slashed interest rates to around 1 per cent and held them low from 2001 to 2003, before slowly raising them. A consequence was that easy credit led to hundreds of thousands of sub-prime mortgages being granted to so called "ninjas" - people with "no income, no job, no assets".
Many new creative mortgages offered loans with very low interest for the first two years, rising sharply after the honeymoon period and containing penalty rates for any missed payments.
It is estimated that the sub-prime borrowers will default on US$200-300 billion. This is hardly enough to threaten the world economy, or even a serious recession in the US. But that's only part of the story.
Banks take mortgages, considered safe investments, then slice and dice them into an array of complex financial derivatives that enable investors to bet on the housing market. In theory, they also allow banks to offload mortgage debts from their books, while producing new finances for banks to on-lend to the housing market.
The derivatives market expanded after the housing bust of the 1980s. Back then, mortgages were kept on the books of the banks, and so were visible, so that when the housing bubble burst, the losses to the banks reduced their asset base and led to a credit squeeze. Subsequently, securitisation allowed the bundling of mortgages into various derivative instruments that, when sold to the financial markets, offloaded mortgage debts from the banks. In turn, the derivatives market was supposed to be the shock-absorber for any future mortgage crisis.
These complex, mortgage-backed derivatives are sold off to pension and managed funds and other institutional investors across the world. This betting process magnifies the value of the original mortgages on the financial markets. The US securitisation market is worth US$3.8 trillion, in an economy worth US$14 trillion annually.
Theoretically, the combined profits and losses on these derivatives will cancel out. In reality, after some investment vehicles sustained huge losses and due to the lack of transparency in the derivatives market, nobody knows who has taken hits and who hasn't. Nobody knows whom to trust and whom not to trust.
The collapse of US Countrywide Financial Corp., the run on Britain's Northern Rock bank, losses by big US investment banks, and the announcement that some Australian banks and local councils have suffered losses - all of these events have spread uncertainty in the non-transparent financial markets.
Many banks are being forced to reabsorb their off-balance sheet housing ventures. This further weakens the capital base of these banks, especially if housing assets are falling in value.Credit markets frozen
Consequently, even many banks don't know the status of their capital base and therefore cannot assess how much to set aside for the job ahead. Some European banks have capital ratios well below the 8 per cent minimum safety margin. Every bank is seen as suspect, and financial markets are reluctant to lend to them. Consequently, credit markets have frozen, creating a liquidity squeeze.
So the world's central banks have stepped in to try to get credit flowing again. The US Federal Reserve has cut rates three times. The first credit package, shortly after the crisis began in August, saw central banks around the world pump US$240 billion into the financial markets. The Federal Reserve pump-primed another US$41 billion into the markets in early November (Australian Financial Review,
November 23, 2007). In December, the European Central Bank released US$500 billion to tide the banks over the new year (The Economist,
December 22, 2007). The US is also planning tax cuts and other economic stimuli worth another US$100 billion.
These record injections into the financial markets have so far failed to free up the paralysed credit system. These packages alone can't solve the fundamental problem. Credit is based on trust, and nobody knows whom to trust because of "the crippling lack of information about potential losses on the sub-prime mortgages and related restructured debt products. Even the banks themselves will remain reluctant to lend until they know how much capital they will need to sort out the mortgage mess." (The Economist,
December 15, 2007).
Some banks have turned to sovereign wealth funds - huge government-owned funds accumulated mainly by the oil-exporting countries - to refinance their balance-sheets.
By mid-January this year, foreign governments had invested US$27 billion in Merrill Lynch, Citigroup, UBS and Morgan Stanley (The Australian,
January 11, 2008). It is ironic to see these most ardent exponents of the free market being bailed out by state-owned investors.
Solving this crisis will require the banks and other financial institutions to urgently re-price their failed mortgage-derived instruments, then evaluate and own up to their losses, offering transparency to the markets. Then there will have to be a way for these institutions to work with central banks to write down bad bank debt and to refinance the banks to keep the credit system flowing.
Learn from Japan. Their banks were slow to admit to their bad debts, and as a result the Japanese property market has been sliding for 17 years!
Solutions will demand new regulations to give transparency to markets where a frenzy of innovation has created a complex derivatives market, which, instead of becoming the shock-absorber of a mortgage crisis, has seized up the credit system.
A reform of the ratings agencies will also be required. Instead of objectively rating these new instruments, the agencies proved to be more loyal to the issuers of the derivatives who were paying their fees.Housing
The sub-prime mortgage system is expected to continue for some years. Yale economist, Robert Shiller, who predicted the peaking of the dot.com boom, believes Americans may have to endure a Japanese-style recession, with property values declining for years (The Australian,
January 8, 2008). In states such as Florida, California and Arizona, property prices have already fallen by 40 per cent in two years.
This is happening at a time when US household debt is so high it has made families the most vulnerable they have been since 1933.
Australia is not facing a sub-prime mortgage crisis. The bulk of mortgages are financed at below 30 per cent of household income.
In fact, the short term could see another quantum jump in house prices with stock-market instability, which traditionally sees funds move from the stock to the housing market.
However, there is one snag. A new survey by Demographia
of 227 major cities found that Australia has the most unaffordable housing in the world. It reported: "On average, Australian families are forced to spend 6.1 times their entire household income to buy a typical home, compared to 3.1 times in Canada and 3.6 times in the US ..."
These figures do not include interest and charges. Australian interest rates are among the highest in the developed world.
This begs the question: will high interest rates on highly-geared mortgages precipitate a housing slide? Will a sliding housing market become the nation's Achilles' heel?- Patrick J. Byrne