Educational Resources

As the new De Niro movie asks - what just happened?

How did global share markets go from riding high a year ago, making new highs, to the fear-racked, slumping disaster-scenes they are today?

How did it come to pass that the global financial system is in danger of collapse?

How did the profusion of sub-prime home loans in the USA cause so much trouble?

Let's go right back to the start of the debacle.

First, some history.

In 1977, the Carter Administration passed the Community Reinvestment Act (CRA), which compelled the banks to make loans to low-income and minority borrowers, with the laudable aim of widening home ownership in the USA: in particular, extending mortgages into minority groups, which had usually found it difficult gaining home loans.

The CRA was not widely used until the Clinton administrations, when it exploded into a trillion-dollar program pumping out low-income mortgages.

The effect of CRA was that banks dispensed with economic criteria when making certain loan decisions. In effect, for certain loans, lending standards went out the window.

This was a known problem, but it really only swelled in magnitude once the Federal Reserve Board cut interest rates in the wake of the September 11 terrorist attacks in 2001 - all the way to a 46-year low of 1 per cent in 2003.

With inflation at 1.2 per cent at the time, real interest rates were negative. In other words, American borrowers were being paid by the Federal Reserve to borrow money.

The cheap money created a housing bubble. All over the USA, real estate values ballooned. Banks and mortgage brokers were eager to make loans. In a flat interest-curve environment, lenders wanted to generate cash flow and create collateral. Home mortgages - statistically the least likely loan type to default - were viewed as money for jam.

Sub-prime borrowers, who did not qualify for conventional mortgages or banks' prime rates, flocked into adjustable-rate mortgages (ARMs), which kicked off at rates of 3 per cent. Sub-prime lending grew to account for 25 per cent of total US home loans. To put that in context, in Australia, 1 per cent of our mortgage pool is sub-prime.

As more sub-prime borrowers got loans to buy houses, house prices were pushed higher. Deposits were no longer required. 40 per cent of all US home loans in 2006 did not require a deposit.

In their search for market share and asset growth, US lenders eagerly went beyond sub-prime to Alt-A or "self-verification" loans, where applicants simply state their income and assets. These "liar's loans" grew to represent about 21 per cent of outstanding US home loans, and 39 per cent of mortgages written in 2006.

US home borrowers were happy to take non-amortising - or interest-only - loans, where no part of the principal amount was repaid. Then, negative-amortisation loans were introduced: not only were the borrowers making no inroads into the principal amount, they were going backwards from day one. These loans were capped at 25 per cent negative amortisation; you could not end up owing more than 25 per cent more than you had borrowed.

The extreme was reached in 2006 with the NINJA loans -where the borrowers had no income, no job or assets.

The only reason why many US borrowers took out such loans was the belief - common in a long-lived housing boom - that they would sell the house for more than they had paid for it. What could possibly go wrong with that strategy?

Plenty. Quite simply, the US overbuilt houses - because of the pressure from people getting housing loans who should never have got them. The home supply reached 11 months' worth of homes: it is considered balanced between buyers and sellers at five months' supply.

There is nothing magic about residential real estate that means it is immune from the law of supply and demand. An over-supplied commodity will fall in price, and US house prices did.

The S&P/Case-Shiller Index, which tracks home values in the 20 largest metropolitan areas in the USA, indicated in its most recent reading, for July 2008 (released on September 30), that US home prices fell by 16.3 per cent from July 2007, the sharpest annual rate ever.

Prices in the 20-city index have plummeted by one-fifth since peaking in July 2006. A 20 per cent fall means a US$4,000 billion decline in the value of US residential real estate value, says Moodys.com.

Individual markets have fared worse. According to Bloomberg, home prices in California - the epicentre of the sub-prime disaster - fell by 41 per cent in August from a year earlier, as foreclosure sales pushed down valuations.

And not only did many US borrowers get loans who should not have got them, they were encouraged to take big loans. In the US, interest on your principal home is tax-deductible; and mortgages are non-recourse - the bank can only rely on the house as security. Borrowers can simply walk away from the loan, and the house becomes the bank's problem.

So, US borrowers could lie about their income and assets to get a bigger loan than they could afford; the bigger the loan they took out, the bigger the tax deduction they got; and they could walk away from the loan without penalty.

Which many have done. It's called "jingle mail": you just slip the keys into a post-pack, and mail it to the bank. That's the end of your loan.

For their part, the banks assumed that property prices would rise forever: therefore, it didn't matter how much money they loaned or to whom they lent it - because the asset would increase in value. Statistically, mortgage borrowers were the least likely to default: but as banks now know, in a falling market they will default - especially if the law makes it painless for them to do so.

In other words, the US home loan market went completely mad, with people over-borrowing and over-committing themselves, exacerbating a bubble in housing - a bubble that has burst. Defaults and foreclosure sales are ratcheting house prices downward, just as the easy-credit boom leveraged prices higher. Moody's.com reckons the US housing market won't be back to normal until late 2009, at the earliest.

But why did this become a problem for the wider financial markets?

The reason is that about three-quarters of the sub-prime loans made in the USA since 2003 were repackaged into residential mortgage-backed securities (RMBS) and sold to investors around the world, attracted by the higher returns. Many of these mortgages found their way into the asset pools that backed securities called collateralised debt obligations (CDOs).

But as US interest rates rose and ARMs adjusted to double or triple the initial interest rate, sub-prime borrowers started to default. House prices began to fall, worsening the default surge. The cashflows that supported the securitised structures began to collapse.

The credit ratings on sub-prime debt securities - and the CDOs that contained them - were downgraded, causing the values of the securities to be slashed.

The contagion began to affect other credit markets around the world - even areas that had no exposure to sub-prime mortgages at all.

In particular, mortgages were sliced and diced into a mortgage-backed derivatives house of cards. Nobody knows which bank is sitting on which liability, and who is a counter-party of whom. In theory, this damage was safely contained off the banks' balance sheets. But in theory, US house prices never fall, either. So the banks have discovered that their special investment vehicles (SIVs) and conduits are no comfort - they have had to bring these contingent liability chickens home to roost on the balance sheet.

The problem with this is that the banks had not set aside enough capital on the balance sheet to back them. That's the whole point of having things off-balance-sheet!

Bringing these exposures back on to the balance sheet has resulted in a river of red ink flowing through the books of some of the biggest names in global finance.

All up, about $US600 billion of mortgage-related debt has been written down so far. The banks have raised capital that replaces only about 70 per cent of the losses.

The International Monetary Fund (IMF) estimates that sub-prime-related losses could go as high as $US1.4 trillion. The IMF says the world's major banks may need up to $US675 billion in fresh capital over the next several years to recover from the credit crisis.

The sub-prime crisis and the US housing slump were the trigger for the crisis, but it was what they revealed that was scarier still - that banks were dangerously undercapitalised. They did not have enough shareholders' equity behind them to survive having to write down assets so drastically. And having written down their assets, the banks' capital ratios are impaired, meaning that they can't lend to the extent they were a year ago.

Because of this, credit, the lifeblood of the economy, has slowed to a trickle. Inter-bank lending rates have surged to record levels, indicating that banks do not trust lending to each other. Without credit, economic growth disappears.

The commercial paper market, where companies tap usually strong demand for bonds to fund their day-to-day needs, also saw activity plunge.

It's this worry about corporate funding that has led to the crashes on world stockmarkets - with financial stocks the worst-affected sector.

So far, the steps taken by governments and central banks have not been able to stem the falling markets. Firstly, the US government announced that it would take the banks' problem assets - the so-called "toxic" debt such as worthless CDOs - off their books.

Then, the major western economies - Australia included - moved to guarantee bank deposits.

Now the governments and central banks in the US and Europe are investing taxpayer money in banks - trying to keep them afloat. Not only are they taking equity in the banks, they are guaranteeing the banks' inter-bank loans. In doing so, they are finally going to the heart of the crisis - the freezing-up of the credit markets.

Free-market capitalism is being saved by government intervention - because the governments sit on the only balance sheets that can invest and lend.

It will be a long way back for the stock markets, but at least the G20 group of major western nations have shown that they're prepared to do whatever it takes to stop the worst slump on the stock markets - and stave off global recession. It's an unprecedented co-ordinated financial rescue plan for resuscitating the crippled credit markets and calming the global investor panic.

The developed-world economies - let alone the stock markets - are a long way from being out of the woods. For instance, unraveling the $60 trillion credit default swap (CDS) market is yet to be attempted - and it could throw up problems that dwarf those caused by the sub-prime crisis. But as October reaches its mid-point, no-one can say that the governments under-estimate the problem and are doing nothing about it. They're doing plenty.

Author: James Dunn Vanguard