Some thoughts on the “credit crunch”.

A lot has already been written about the poisonous confection that is the credit crunch: a quick google produces nearly 12 million references (a quarter of them originating from the UK). The phrase has been on the lips of newsreaders on radio and tv, and pages and pages of newsprint have been produced about it.

But none of it by me, so I thought I would add my tuppence worth. I doubt anything I have to say won’t have been said by others, and, not being an economist, some if not all of my economics may be wrong… I have split this over two posts, because it got too long!

Back in late November, I went to a talk by David Cruikshank of Deloittes, where he is chair of the UK part of the firm and head of tax, on the credit crunch, what went wrong and the implications for business.

He started from the orthodox view that the credit crunch was started in the USA as a result of Asian (predominantly Chinese, who were saving 50% of their GDP) money looking for a home – that money had to go somewhere. With relatively low interest rates – money was cheap as a result of the “Greenspan put”, when interest rates were cut following the last asset bubble in 2000 (that time, it was technology shares in the dotcom bubble) – investors (individuals and institutions) sought to invest in riskier and riskier assets to provide the yield they desired; this of course pushed up asset prices and reduced the yield for investors – who then sought riskier, higher yielding investments. A vicious circle.

This lead to a housing bubble in the US (as well as inflated values for other investments around the world, including UK houses and shares) and a rise in individual and corporate debt. Financial institutions found ways of packaging up the debt to finance more lending: essentially, moving it off balance sheet by selling it on, in investments made by cutting the debt into chunks (“securitisation” – not so secure now!). The creation of these debt derivatives seems like a classic mistake, in that it removed the responsibility for managing the debt from those lending the money to borrowers: investors buying the derivatives relied on debt rating agencies such as S&P to verify the credit-worthiness of the derivatives, and the relationship between lender and borrower was broken.

The market for these derivatives – such as collateralised debt obligations (CDOs) – came from all those investors looking to park their money somewhere. To provide “insurance” against these derivatives going bad, institutions used another derivative – credit default swaps (CDS) – which would pay out if the debtor defaulted. CDS were issued by other financial institutions. Between 2003 and 2007, the worldwide market in CDS increased ten-fold to $45 trillion. (Compare that to the GDP of the USA in 2008, estimated by the IMF to be $12 trillion.) Interestingly, one can buy CDS without owning assets – they can be used as a speculative investment: you simply buy CDS in a company you think might go bust.

So we have institutions creating derivatives, selling them on, and buying insurance from other institutions to cover defaulting, together with investors speculating in companies going bust.

The increase in asset prices – real, financial, and commodities – lead to inflation; central banks started raising interest rates: in the US, rates started rising from 4.25% in August 2005 to 8.25% in July 2006, a near doubling of interest rates. (In the UK, rates went from 3.75% in July 2003 to 4.50% in August 2005, where they stayed for a year before peaking at 5.75% in July 2007 – still an increase of over 70 percentage points.)

People who had borrowed at the lower rates faced greatly increased interest payments; and those who could least afford these rises – the so-called subprime borrowers – started to default. The bubble was pricked, firstly in the US, where house prices fell as subprime homeowners lost their houses. Another vicious cycle: with decreasing asset prices, the institutional lenders lost their security, causing them to call in their loans quicker than they would otherwise have done (and thereby reducing asset prices further).

Institutions holding CDOs and other derivatives started to suffer losses on their investments. The trouble was, with the holders of the derivatives separated from the originating lender, they had no idea of the quality of their holdings. Worse, they had no idea of the quality of other institutions’ holdings: so institutions stopped lending to each other, in case they were left hold a bad debt (a bit like a game of pass the parcel with risky assets).

Thus the collapsing bubble became the credit crunch: banks stopped lending to each other and to customers, and credit became very tight. Banks also risked going bust: Cruikshank gave the example of Goldman Sachs, which had reserves measured in billions but liabilities of trillions: losses of 5% on those liabilities would wipe out the reserves. (Goldman hasn’t gone bust, although it has had to become a bank holding company, being subjected to a different regulatory regime, and recapitalise its balance sheet.)

So this is how we got to where we are, with some large banks failing and others being effectively nationalised in the USA. the UK and Europe.

Banks are still not lending to each other, nor are they lending to customers. With access to money, people aren’t buying assets and asset prices are continuing to fall.

Governments have invested in the banks – the US government has made available $700 billion, which puts the £37 billion investment in UK banks in the shade – and $6 billion in the US car industry.

This is where we are; my thoughts on what is going on will follow in another post.

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