No money down
It is famously said that a butterfly flapping its wings in Brazil can cause a hurricane on the Florida coast. But how did mortgage defaults in the United States lead to queues around the block outside banks in this country?
Back in 2001 the American economy was reeling under the double blow of the bursting of the dot com boom and the September 11th terrorist attacks. In order to keep the economy buoyant, the Federal Reserve cut interest rates 13 times between 2001 and June 2004 in an effort to boost consumption and prompt the US to spend its way out of the nascent recession. By December 2001 the Federal Funds rate was down to 1.75%.
Interest rates are simply the price of money. A 5% annual interest rate on a loan of £100 will mean that you will eventually pay back £105 if you pay it off at the end of the year. And, as interest rates (the price of money) fell, people suddenly found they could afford loans. These keen borrowers found eager lenders.
The lenders had a brand new way of working. Traditionally they could loan someone money to buy a house and they would have kept the house as collateral. Now, they sold the debt on the debt market to, let’s say, Third Party Inc. In essence, the mortgage repayments would now be going to Third Party Inc and, in the event of default, Third Party Inc would repossess the house and sell it in order to make back its initial outlay. These bundles were known, among other things, as Collateralised Debt Obligations (CDO’s).
But that wasn’t all. Third Party Inc could take this debt and package it with another one. The idea was that this would insure one with the other in the event that it ever turned sour. Risk spread was supposed to be risk lessened.
Sadly, these derivatives were less like steel rivets spreading the load through the structure of a building, and more like the cracks in a dam ready to burst. Back in 2003, Warren Buffet called them “financial weapons of mass destruction”. Nevertheless, the trade in these derivatives boomed as they were packaged and repackaged, sold and resold, and they shot through the global economy like shrapnel.
The insatiable appetite for more debt to be repackaged and resold led lenders to look to people with bad credit histories, who, with interest rates so low, could afford to take the debt on. This was the now infamous ‘sub prime’ market. And as new borrowers with cheap credit flocked into the market house prices boomed. In 2004-2005, five US states recorded house price rises of more than 25%.
But then the sub prime market dried up. Interest rates were now on the way up and borrowers were unable to keep up repayments. Defaults rocketed and lenders suddenly found themselves in possession of houses. The lenders tried to sell these homes to recoup the original loan but found that, with the cost of borrowing rising, new borrowers had been priced out of the market. This sudden rush of repossessed homes coming onto the market coupled with a reduction in potential buyers caused the value of the lenders assets to tumble. In parts of the US a house is cheaper than a new car.
Like a game of pass the parcel, the music had stopped and banks all over the world were anxiously unwrapping their CDO’s to see who was holding a portfolio of worthless bungalows in Florida or Michigan.
This was the credit crunch. Banks were no longer sure if the other banks were prime or sub prime and became reluctant to lend to each other. From August, when the squeeze began, the Interbank rate, the interest rate which banks charge each other, leapt by 75 points in four months. Money stopped flowing and credit dried up.
When the bottom was reached and banks sat, shocked and surrounded by torn parcel paper, the losses were posted. Merrill Lynch: $7.8 billion, JP Morgan: $1.3 billion, Citigroup: $9.8 billion, Morgan Stanley: $9.4 billion…
But how did the flapping butterfly, unable to meet its mortgage repayments or lend money to its fellow banks, lead to the hurricane which swept through Britain leaving desperate queues outside banks, a potential liability of £3000 for every British household and a nationalisation in its wake?
Traditionally people deposit money with banks who would then lend it out charging interest. Northern Rock had hit upon a different idea. Instead of limiting their lending to an amount backed by deposits, they funded their mortgage loans by borrowing on the money markets. For a while it worked and Northern Rock’s profits soared.
But when, in August, the credit market seized up, Northern Rock ran out of cash. In desperation, the bank went to the Bank of England on September 13th to ask for an emergency loan. With the credit market in a coma it looked as though other banks would soon be in the same situation. Their share prices began to fell, that of Alliance and Leicester providing a notable source of worry.
Were back at the creaking dam metaphor again. With a banking crisis in the offing the government piled in to prop up Northern Rock. But the law of unintended consequences came into play as Rock’s depositors took this government intervention as a sign that the bank was doomed. They began withdrawing their savings no matter how long they had to queue.
Thus, the government was called on to lend more and more. They desperately sought a buyer for the stricken bank which would guarantee repayment of the massive sums lent. However, due to the ongoing credit crunch, no buyer could afford to borrow the money to finance a takeover. The government, the taxpayer, you and me, were left holding the baby. By mid January the treasury had spent £55 billion to shore up Northern Rock. Compare this with the annual defence budget of £33 billion.
On February 17th the government gave up its forlorn search for a buyer who would take Northern Rock off its hands and nationalised it. The aim is to run the bank until a private sector buyer can be found. To do this, the bank will have to be running at a profit so as to attract buyers and this means that the government will be competing for market share with other banks. One wonders how shareholders in these other banks will feel now that they are subsidising a competitor since we all became shareholders in Northern Rock.
There is no telling how long this period of government ownership will last as a falling housing market makes mortgage lenders, such as the Rock, a bad investment. In the 1960’s and 1970’s the British government nationalised many struggling businesses in order to keep them going, such as Rolls Royce and even a brewery, but they often found themselves lumbered with them for the long term. Also, we now have the unpleasant prospect of the government, as owner of Northern Rock, having to evict home owners who fall behind with repayments.
What are the prospects in this grim panorama? In a situation like this, government can typically use either fiscal policy or monetary policy. In this instance, monetary policy would mean the lowering of interest rates with the hope of cutting the price of money and getting people borrowing and spending again. Fiscal policy would mean tax cuts with the aim of increasing people’s disposable income and prompting them to get back into the shops or estate agents.
The US has followed an aggressive fiscal policy. On February 13th the US Congress, with uncharacteristic speed, passed $168 billion worth of tax cuts and investment incentives, about 1% of GDP, in an effort to pump cash back into the economy.
This is not without risks. George W Bush inherited a budget which was in surplus to the tune of $236 billion but has seen this transform into a deficit of $286 billion. The US has got away with this profligacy thanks to the willingness of much of the rest of the world to hold dollars. But, as the US continues to splurge currency around the planet, these dollars are worth less and less. Soon, countries such as China and the Gulf states will begin to question whether they are content to hold onto an asset which is falling in value. The tax cuts are only likely to accelerate this process.
Gordon Brown and Alistair Darling may have even less room for manoeuvre. Despite his reputation for prudence, Gordon Brown has overseen a budget surplus of £14 billion in 2001 turn into a deficit of £43 billion in 2007. As demonstrated by the recent dispute over Police pay, the governments’ tight finances leave it with little room to cut taxes without pruning services further than already planned.
America and Britain have also gambled on an active monetary policy. America’s Federal Reserve has been on its biggest interest rate cutting spree in 25 years and rates have now fallen by 2.25% since the August crunch to just 3%. The Bank of England has gingerly followed suit with rates cut from 5.75% to 5.25% between August and February.
The problems with this are obvious. It was a glut of cheap money which started this whole process in the first place and we are right back to where we started. Besides, with the Fed cutting rates from what was already quite a low level, it has to be asked just how much more scope there is for further cuts. With inflation at a little over 2%, interest rates of 3% are barely positive as it is.
In Britain monetary policy runs into problems of inflation. As interest rates are cut more money flows into the economy. Yet, unless there is a corresponding increase in output, this money will be chasing relatively scarcer goods and inflation, or the rate at which prices rise, will increase.
The Treasury has long fiddled the figures on inflation by using the Consumer Price Index as a measure which leaves out spending on things, like mortgages and Council Tax, which have been rising fastest. Whereas CPI has inflation running at 2.1%, the broader Retail Price Index has it at 4%. A survey of British workers, which showed their expectations of inflation in the coming year to be 3.3%, suggests that the RPI might be nearer the mark and that the Chancellor has less room for manoeuvre than may be apparent.
But saviours may be ready to ride over the horizon, only they will be wearing Arab robes and Chinese sandals, not suits of armour. For decades the west, and the US in particular, have been spending more money than they have coming in. As a result countries all over the world have found themselves sat on vast reserves of foreign currency. Now deployed by governments as instruments of economic policy, they have become known as the sovereign wealth funds. Since August last year these funds, valued at around $2.9 trillion, have injected $69 billion into western banking.
Whether this is a good or a bad thing depends on how you feel about Globalisation. Though there is a certain irony in the rich world being bailed out by its developing neighbours, it does at least show that economic muscle is not as concentrated as it once was.
But while this welcome cash may be a good short term fix, it is not a long term proposition. The sovereign wealth funds are funded by savings, like the 40% of GDP which the Chinese have saved up. But, as these countries become more affluent, their people are going to want a more affluent lifestyle and this means they will have to save less. As the Chinese decide to eat more of the meat or wear more of the designer clothes their rising incomes can now buy them, the sources of the sovereign wealth funds riches will shrink. This bail out may well be a one off event.
Ultimately, whether it is monetary or fiscal policy or the unknown quantity of sovereign wealth funds, this is a problem caused by an excess of cheap money being solved with another dollop of cheap money. A line from Alice in Wonderland seems all too appropriate for this story; “That’s the reason they’re called lessons,’ the Gryphon remarked: ‘because they lessen from day to day’”