Bizhack.net

A lot has been written in the press about the credit crunch, sub-prime, CDOs and the like, but what does it all mean, how did it happen and what effect will it have on the average person?

Following the bursting of the tech-bubble in the early years of the millennium the U.S. Federal Reserve aggressively cut interest rates in order to prop up the markets. Inadvertently this deluge of cheap money caused a bubble in asset prices as consumers worldwide went on a spending binge funded by credit. Consequently house prices across the developed world appreciated at an extraordinary pace, leading to many consumers funding their increased spending habits through borrowing against the inflated value of their homes. Banks and lenders, seeing the margin on high quality lending contract, searched for yield by offering money to less-creditworthy individuals and institutions with fewer restrictive covenants. The epitome of this phenomenon were so-called NINJA loans – no income, no job or assets: no problem! And the reason that banks could originate these kinds of mortgages in record quantities (the sub-prime section of the U.S. mortgage market, representing loans to the least creditworthy of people, accounted for over a quarter of the whole mortgage market) was that they were packed up into asset backed securities, rated by the ratings agencies, and sold to institutional investors in the wholesale markets. And the reason that investors bought these securities? Because with yields falling they could earn a pick-up over similarly rated government bonds, ostensibly for the same risk (the mispricing of risk is a whole other topic). In fact, these securities were repackaged again into collateralised debt obligations, CDOs, which in turn offered an even higher yield for a given rating, and again into second and third generation structured products.

As with every bubble there follows a burst, and this particular bubble was no different. With defaults and delinquencies rising on the lowest quality loans losses were seen on sub-prime backed securities, prices collapsed as a flight to quality ensued and fear spread throughout the global financial system. The effects have been felt first and foremost by the banks who held these assets, but also other banks reliant on the inter-bank market for funding, and also by corporates who, affected by tightening of credit lending standards, have felt the pinch as their funding becomes harder to source. Even institutions with no exposure to these securities have been dealt a hard blow as other assets have seen a decline in value. Indeed European asset backed securities continue to perform well with few exceptions, however they have been tarred with the same brush and so have seen a decline in their prices. The pain is also now being passed on to the consumer. While lending standards in Europe never became as lax as they were on the other side of the Atlantic, there was a loosening of standards as institutions looked for aggressive growth, relying less on lending from their deposit base and more from the wholesale markets. As this source of funding dried up mortgage lending contracted. This state of affairs came to a head with the nationalisation of Northern Rock and with the announcement this week by a number of mortgage lenders that they are to pull out of originating new mortgages, some temporarily and some permanently, and that they are to increase the rates charged and the deposit required in an effort to cut their share of the new lending market.

So what happens now? We probably won’t see Dutch auctions as are currently happening in Spain in order to clear the backlog of unsold homes, but conditions are likely to get worse before they get better. As mortgages are harder to come by homes will be harder to sell and prices, which have already shown a large decline, will continue to fall. However as with many occurrences in life these things go in cycles. Eventually we will hit a bottom and come out the other side. House prices will begin to appreciate and when they do, with more stringent lending standards re-introduced, the system should be a lot more robust.