What started the credit crisis ?

How did  the American sub prime mortgages crash the world economy!!

Dummies guide to the credit crunch

THE global credit crunch was a year old last week, a very unhappy birthday for the world economy and one whose repercussions could be both historic and far-reaching.

Many fantastic figures about the crunch have been bandied around, often expressed in trillions of dollars, so it is difficult to get a realistic grip on what caused it, what it actually means for ordinary Australians and whether it really is — as some would have you believe — the end of the world as we know it.

So, here’s a foolproof guide to the crunch: something everybody can understand — though you may find it depressing reading.

( Q ) What caused the credit crunch?
( A ) OK, it all goes back to the US property market and some very sloppy lending practices.
Banks and unscrupulous mortgage brokers were giving mortgages to so-called sub-prime borrowers — people who clearly could not afford to pay; but the banks and brokers didn’t care because (a) house prices were rising, so they could repossess and sell for a profit; and (b) the brokers were being paid huge commissions for arranging these loans.

( Q ) And what happened after that?
( A ) Well, suddenly, the bubble burst. Property prices had been rising at an unsustainable rate until a combination of oversupply, rising interest rates and increasing defaults burst the housing bubble.

Banks quickly realised many borrowers couldn’t repay their mortgages, especially those sub-prime borrowers.
Crucially — unlike in Australia and the UK, where you are liable for the debt — in the US you can just hand back the keys and walk away, leaving the bank to worry about the house and the mortgage attached to it.

In the past year, property prices in the US have fallen in some areas by as much as 50 per cent and are still falling, with people throwing keys back to the banks by the thousand.

( Q ) Why did big US banks — such as Bear Stearns — start going bust?
( A ) Because this was no ordinary house price crash. Like the treacherous rocks that are exposed when the tide goes out, falling US house prices revealed a hellishly complex and unimaginably valuable series of investments — all linked to the US housing market — that had enticed investors, including banks, from all around the world, including Australia.

( Q ) What were these investments?
( A ) This may sound like jargon, but bear with me — I promise, it’s easy to understand. The most popular investments were credit default swaps (CDSs). CDSs are a form of insurance linked to a company’s debt.

For example, say an airline wants to raise money to buy more planes: one way of doing this is to sell corporate bonds.
Investors buy the bonds, but want to hedge their investments, in case of default by the airline. So they buy a CDS, which will pay out if the company defaults. The seller of the CDS promises to pay the airline’s debt if it goes bust.

All types of companies issued bonds — including mortgage companies, such as Fannie Mae and Freddie Mac — and CDSs attached to these companies’ bonds soon became huge for investors trying to lower their risk in the market.

But CDSs soon became a speculator’s dream because — and this is the really mad part! — you do not need to own the bond or debt to take out insurance against it.

It’s a bit like buying insurance on somebody else’s house and getting a payout when it burns down. If the house burns, you suffer no loss — you just get a big payout like the owner. And because you don’t need to own the house to take out insurance on it, there could be 20 or 30 or even 1000 people who have insurance policies against this one house — and that means payouts in the event of a catastrophe could be unimaginably huge; big enough to bankrupt big banks.

( Q ) OK I’m beginning to understand now … but what else?
( A ) It gets worse, because banks that sell CDSs usually try to buy CDSs from other banks to hedge their own bets — and that means that if a big payout is needed and one bank can’t pay, the next bank down in line is in big trouble, because it then can’t pay the next bank it owes money to and so it goes on — a terrible domino effect.

The sums of money involved are huge. Fannie Mae and Freddie Mac in the US sold bonds against half the mortgages in the US — and nobody knows how much insurance that banks have bought and sold to each other, and which is linked to those bonds.

( Q ) How big is the market for these CDSs?
( A ) It has grown massively in the past few years, as people realised what a low-risk way it was of making a killing, at other people’s expense. In 2001, the market in CDSs totalled $918 billion — that has risen to a mind-boggling $62 trillion today.

That equates to $10,000 for every man, woman and child on the planet.

( Q ) So, how does all this affect me?
( A ) Well, given that almost all banks invested in these CDSs and that nobody knows how much they may have to pay out, banks simply stopped lending to each other and that, in short, is what led to a massive drying-up of global credit. Nobody trusted the next bank down the line, so everybody stopped lending money — or, at least, charged a much higher profit margin to compensate for the higher risk.

( Q ) Are Australian banks affected?
( A ) Yes, in two ways. First, there is the increased cost of credit filtering through to mortgages. Australian banks get half, or even more, of their mortgage funds from the international money markets and this source of funds has become more expensive since the crunch. That has led to the banks hiking rates, separately from any rises by the Reserve Bank (RBA). In the past year, the RBA has raised rates by 1 per cent, but the banks have added about an extra 0.5 per cent of their own.

Secondly, there have been banks, such as ANZ and NAB, announcing big provisions for bad debts, linked to the US sub-prime meltdown. That’s bad for shareholders, too.

However, Gavin White, of derivatives trading firm City Index Australia, says it’s difficult for banks to say exactly how much they may have lost.

"Banks only have to own up to their losses if they think it will have a material effect on their share price. ANZ and NAB have both come out and said they have got losses related to the US meltdown and Westpac and CBA both said losses were small,” he said.

"The problem is, its very difficult for anybody to value these investments, particularly CDSs, because you don’t know the value of the debts that they are linked to. It’s a nightmare.

"It will be some time before all of this is cleared up. In the meantime, borrowers have to live with increased mortgage costs and the very real possibility that banks won’t pass on any interest rate cuts by the RBA because, they argue, their funding costs have gone up so much.”

( Q ) So, will all this business end soon?
( A ) There’s no end in sight yet. One legacy that we can be relatively sure we’ll be living with for a long time is a dislocation between the RBA’s cash rate and mortgage rates.

Already, NAB, Westpac and CBA have said they may not pass on any rate cuts, irrespective of any action by the RBA. And the increased cost of funding has had the other side-effect of pricing many non-bank lenders out of the market because they simply can’t compete — they don’t have the luxury of having savers’ deposits to draw on, to lend out.

Also, a big source of funds for all lenders was raised by a process called `securitisation’, whereby a bunch of homeloans were packaged up by lenders and sold to investors. Investors liked these deals because they got a good cashflow from mortgage interest repayments.

But after the crunch, the market in securitisation dried up.
So, until funds become cheaper, banks look set to dominate. While banks around the world write off billions of dollars in losses, Australian banks might actually end up regarding the credit crunch as the best thing that could have happened to them, because it has wiped out their competition.

Big banks now account for 90 per cent of all new mortgages. And that could mean their profit margins will get bigger.
However, as somebody recently said, there’s one thing worse than a greedy bank with huge profits — and that’s a poor bank that won’t lend.

In the UK, more than three-quarters of all mortgages have disappeared in the past year as banks struggle to find the money to lend: in the UK, the banks’ exposure to CDSs was much, much bigger than in Australia, so banks there still don’t trust each other enough to lend money.

That is causing house prices in the UK to fall at the fastest rate on record.
We must hope there are no skeletons in the cupboards of Australian banks, otherwise the same could happen here.

Article by Nick Gardner


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