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What caused the credit crunch?

The credit crunch made easy

The housing market slowdown in the USA has instigated fears that the world could be headed for a double recession. This was one of the many topics I discussed on phone with an old mate in Kampala. However, when he asked, ‘but what exactly happened?’, it transpired to me that while people across the world have been at the receiving end of the financial crisis, its origin is still unknown to many.

Two major factors ignited the financial crisis – sub-prime mortgages and investment bank failures. This article explains in a layperson’s language one of the key root causes – sub-prime mortgages.

Although, the activity was widespread in North America and Western Europe, the discussion concentrates on the USA (the main culprit) both for simplicity and because of its influence on the global economy. The Governor of Bank of England once commented that, ‘when the USA sneezes, the rest of the world catches a cold’. This is because USA’s economy accounts for about 20% of the world’s total wealth, almost equivalent to the European Union (21%).

Mortgages are loans given by banks specifically for buying property (domestic and commercial houses) to own or rent-out. Because they involve significant sums of money, repayment is spread over a long time-period, usually up to 25 years or up to retirement age, whichever is shorter. A sub-prime mortgage is a type of mortgage offered to borrowers with a greater-than-average risk of defaulting on the loan.

Banks are able to borrow large sums of money from each other at lower interest rates, which they re-lend at higher interest rates and make profits. Towards the end of the 1990s and during the first half of the 2000s, certain banks developed niche (specialised) property market mortgages.

The property market in the USA was booming throughout the above period. Demand came from first-time buyers, existing property owners wanting to upsize, those investing in rental properties, and the fortunate able to buy second and/or ‘holiday’ homes. That meant that demand for property was higher than its supply, and that prices could go only one direction – upwards.

A dynamic credit-creation environment and a cyclical flow of money were established. Banks gave out loans and earned interest; people bought property from property developers; property developers retained profits, but paid off old loans and got new loans for new developments. Banks saw this as an opportunity to make money.

A mortgage should in principle be less than 100% the market value of the property. Therefore, customers should put a deposit on their property. This ensures that customers bear some risk in the investment, which they can lose if they default. If the customer defaults, then the bank repossesses the property and sells it (even at a discount market value) to recover its capital. The customer could lose all or some of the deposit depending on the resale price.

Income multipliers (ranging from 3.5 to 5 times the total annual income, less other outstanding outgoing commitments – i.e. existing loans) are used to decide the maximum amount that can be loaned to customers. This ensures that customers secure mortgages they are able to repay.

Unfortunately, the monthly appreciation of properties combined with their high demand convinced mortgage lenders that the above security mechanisms weren’t necessary. Their argument was, if the customers defaulted, the banks would simply repossess the properties, whose values would have appreciated anyway, and resale them at higher prices because demand was high!

It got to a point when it made competitive sense to offer customers 100% mortgages – i.e. no need for a deposit! Then it got worse. It was more competitive for banks to offer customers more money than the value of the property [i.e. (100+X)%] – because after a few months the property value would be more than the current (100+X)%. Meanwhile, the banks would be earning more interest. So it was possible to get a mortgage, which could buy you a property and to furnish it to your taste!

For the same reason, the income multipliers also seemed not to matter. They were literally doubled to between 7 and 10 times the annual income!

The banks overlooked one fact –USA is ‘a land of plenty’. Houses are built on land, and there is a lot of land in the USA– very cheap land!

Property developers sensed an opportunity from the high property demand, acquired land and developed it to a point when supply outstripped demand. A matrix of more properties and less customers meant that prices could go only one direction – downwards, reversing the fortunes!

The property market became so competitive that some developers started selling property below the market value to recoup some of the capital. This competition set the property prices tumbling – the property bubble burst.

Mortgage customers are usually given favourable interest rates during the initial years. After the grace period, the rates go up, often quite considerably.

The tumbling property market made banks to withdraw low interest deals. As customers transcended from their initial low into higher interest rates, some (especially those who borrowed beyond their means) were overwhelmed by the scale of their mortgage repayments. Getting a re-mortgage deal from another lender was out of question without a deposit, which many customers didn’t have. There was no equity from the properties because the outstanding mortgages owed to banks exceeded the market values of the properties! Besides, it became a lot cheaper to rent property from the desperate land lords/ladies.

Customers who had taken 100% and (100+X)% mortgages didn’t have anything to lose because they had made no deposit and, therefore hadn’t taken any risk in the investment. Why pay a mortgage of say $150,000 (the property value at purchase time) when the property is currently worth only $80,000. Faced with the above scenarios, they opted to be declared bankrupt.

Customers still in a position to buy preferred to play the waiting game in order to get better deals – wait for prices to fall lower! Banks were stuck with bankruptcy repossession properties, which they were unable to sell. Property developers were stuck with new properties which they couldn’t sell.

Property developers were unable to repay their loans. Consequently, banks were also unable to repay their inter-bank loans. Subsequently, the dynamic credit-creation environment and a cyclical flow of money were brought close to a stand-still. The ‘risk virus’ entered the entire banking system due to the inter-bank lending mechanism – hence the crisis.

In summary, the financial crisis was a result of pure greed – greed from the banks to maximise profits, and greed from the customers who wanted to live beyond their means!

 

One response to “What caused the credit crunch?

  1. bedsidereadings

    October 22, 2011 at 9:28 pm

    I totally concur with your conclusion; pure greed!

    Listen to audio:-Prosecuting Financial Titans.

    Background:

    – The tide of deregulation; the drumbeat of warnings:- Time Line.

    POLITICS:- White House Philosophy Stoked Mortgage Bonfire.

    Years before the current economic crisis, law professor and former Wall Street trader Frank Partnoy was warning about the dangers of risky financial practices.

    by Sam

     

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