A foreclosure sign goes up on the lawn of a home in Egg Harbor Township, N.J. (Associated Press/Mel Evans)
A quick romp through the credit crunch
Or... … how the financial system was not ready for subprime time
Last Updated July 11, 2008
These are wild and uncertain times in the financial world. Consider what's happened in the past few weeks and months:
- Gold has hit $1,000 US an ounce.
- Oil has hit a record $145 a barrel.
- Stock market volatility is back with a vengeance.
- A major investment bank is brought down two days after its CEO said everything was fine.
- Central banks slash interest rates and pour huge amounts of money into the financial system, and then start raising rates to fight inflation.
- Several hedge funds collapse.
- Banks write down hundreds of billions in suddenly-troubled assets.
- U.S. home prices fall faster than the foreclosure signs go up.
- Investors around the world learn that their supposedly secure money is now at risk — end up in complex financial products they've never heard of.
- Talk of recession fills the air.
- And everywhere, people wonder where the next problem will erupt and how bad it's going to get.
Welcome to the credit crunch. And it really is the financial world's version of the twilight zone. So how did this all get started? Analysts point to several triggers — poor regulation among them — but the first direct domino to fall was unquestionably the unraveling of the U.S. housing boom.
And what a boom it was. The U.S. housing market had stagnated after the recession of the early 1990s and was itching for something to goose it higher. After the dot-com collapse of 2000, the U.S. Federal Reserve dropped its key lending rate to a rock-bottom one per cent. Real estate prices began soaring by double-digit percentages. In some cities — like Las Vegas, Miami, and Phoenix, Ariz. — houses were rising in value by 20 to 30 per cent a year by 2004. Americans wasted no time tapping into their home's skyrocketing worth through lines of credit. The boom in home prices was, in effect, powering a growing share of U.S. consumer spending. Times were good.
Home ownership may be the American dream, but millions of poor Americans were denied that dream. They couldn't save a down payment, or they didn't make enough to afford mortgage payments, or they didn't have a good job, or any job, for that matter.
Not a problem, as it turned out. About 10 years ago, Wall Street invented subprime mortgages. These were loans targeted at people who couldn't qualify for regular mortgages because their credit records were not good enough (i.e. subprime). They came with higher interest rates. But for the first couple of years, those rates were far lower — "teaser" rates, as they were known. People who took out these mortgages were told they would never have to worry about the interest rate reset two years down the road because they could always just refinance the home. After all, home prices were steadily rising. No down payment needed.
NINJA was the acronym for the people who became some of the biggest beneficiaries of subprime mortgages — No Income, Job or Assets.
Now why, you're asking, would financial institutions lend to a group of people who would be extremely unlikely to pay their debts if even the slightest thing went wrong?
For one thing, the sellers got lucrative commissions for each mortgage. But the real selling point for issuers was that they didn't need to worry if the borrowers defaulted. The issuers sold these subprime mortgages to others in a process known as "securitization." That took the original subprime loan off the original lender's books and transferred the default risk to the buyers.
These newly "securitized" mortgages would then be bundled with other loans into complex financial instruments with names like collateralized debt obligations (CDOs). With lucrative commissions at stake, the financial industry demanded more and more CDOs, helping to further drive growth in the U.S. subprime mortgage market. Around the world, companies, financial institutions, pension funds, and investors small and large snapped up slices of these products, which tended to yield a bit more than the traditional savings products.
Investors could often buy these new financial instruments by putting down only a fraction of their worth. That leverage could greatly magnify returns — a good thing when values were rising, but terrible news in a falling market.
Bubbles, of course, always burst. And by 2005, the U.S. real estate party was starting to deflate. Home prices stabilized. Then, they started falling. Subprime borrowers found they couldn't afford the higher mortgage rates once they reset. They couldn't refinance, and they couldn't flip for a quick profit. The great American house party was about to end.
By early 2008, about one in 10 U.S. homeowners owed more on their homes than their homes were worth. Among those who'd bought in the last three years, a staggering 30 per cent were "under water" — in other words, had negative equity.
Foreclosure rates soared, with predictions that as many as 2.5 million Americans could eventually lose their homes.
Homebuilders laid off thousands as people stopped buying and the glut of unsold homes reached new highs. U.S. housing starts were in freefall.
If the trouble had stopped with the housing markets, that would have been one thing. But this problem had legs.
Many firms found that when they tried to sell their neat little bundled debt product, no one wanted to buy it. The problem was one of transparency. No one knew how much of the subprime junk was bundled into which product.
Credit markets around the world reacted to the problem by making it more difficult to borrow money. Short-term interest rates began to creep above the target rates central banks set. Sometimes, banks wouldn't lend to each other at any price. Liquidity dried up. Cash hoarding became common.
Bear Stearns — a Wall Street icon that had survived the Great Depression — collapsed in the face of a run by investors and the inability to borrow money. It had invested heavily in mortgage-backed securities.
Total worldwide writedowns and asset losses from the financial crisis reached $230 billion US by March 2008. Canadian banks are responsible for about $6.5 billion US of that, with CIBC and Bank of Montreal taking the biggest hits. There are predictions that once it's all over, the red ink could top $600 billion US worldwide.
In Canada, the market for about $32-billion Cdn worth of this debt — called asset-backed commercial paper (ABCP) — froze completely in August 2007. More than a thousand retail investors — most clients of Canaccord Capital — are still waiting for their money. They're especially angry because the ABCP had a top credit rating.
By the fall of 2007, it was clear that the U.S. housing collapse and the resulting fallout had the potential to threaten the global economy. The U.S. Federal Reserve began aggressively lowering interest rates amid signs that American consumers were starting to put away their wallets and purses. The Fed, the Bank of Canada, and several other central banks injected huge amounts of money into the financial system to lubricate a worldwide lending machine that had become very reluctant to lend.
Central bankers and politicians around the world rushed to reassure panicky investors that the underlying financial system was solid. In the U.S., the Bush administration spent $168 billion US on an economic stimulus package to get people spending their way out of what many market observers have already declared a recession.
In Canada, the rate cuts have been more modest, the writedowns not as deep. But there have been other effects. It's more difficult to raise money now. Investors in bank stocks have seen the value of their holdings drop by 20 to 40 per cent in less than a year as the market fears further writedowns.
Our housing market avoided the pitfalls south of the border thanks to tighter lending standards and an economy that's still churning out jobs. But analysts forecast that the financial mess and resulting U.S. economic downturn will help to lower the country's 2008 GDP growth to as little as one per cent.
The subprime meltdown and the associated credit crunch have prompted a lot of finger-pointing … and some obvious questions.
For instance, how could U.S. lending standards become so lax? How could subprime mortgages be offered — often under fraudulent circumstances — to people who clearly couldn't afford them? How could these mortgages be bundled with other debt and then sold to investors with so little disclosure about what they were buying?
And there are broader questions that go beyond the subprime mortgage field. Like: How could credit-rating agencies give a "thumbs up" rating to complex structured products that turned out to contain risky subprime debt? Is it time to rein in the complex and largely unregulated financial instruments that gave the financial world such enormous profits over the past decade? Should investment banks be subject to the same degree of regulation as commercial banks? Should derivative products face the same scrutiny as stocks and bonds?
Government, regulators and investors all want answers. Even as it licks its wounds, the financial world finds it has a lot of explaining to do.
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