It is often said that bankers have short memory; hence they repeat their errors. We have witnessed a financial crisis every ten years over the last three decades. In 1980’s the savings and loans debacle cost U.S. tax payers US$200 billion. In 1990’s the Asian financial crisis bankrupted many Asian banks and corporations. The clean up cost taxpayers billions of dollars. Today, another financial crisis emanating from the collapse of  U.S. subprime mortgages has generalized into a credit crunch.

It is often said that bankers have short memory; hence they repeat their errors. We have witnessed a financial crisis every ten years over the last three decades. In 1980’s the savings and loans debacle cost U.S. tax payers US$200 billion. In 1990’s the Asian financial crisis bankrupted many Asian banks and corporations. The clean up cost taxpayers billions of dollars. Today, another financial crisis emanating from the collapse of  U.S. subprime mortgages has generalized into a credit crunch.

The subprime mortgage blow out surfaced in June with the collapse of two hedge funds managed by Bear Stearns. It quickly affected the financial markets worldwide and reached crisis proportion in August-September when it temporarily froze up the money market sector, the lifeblood of the banking industry.  That immediately prompted the ECB and the Fed to pump in $100 billion of liquidity into the system. The money market sector has calmed down, while the stock markets which was initially cheered is now gyrating. Whether this represents a temporary respite or the end of the crisis remains to be seen.

Subprime mortgage simply means lending to home borrowers with weak credit by providing teasers like minimal down payment, low introductory adjustable rates, and lax credit checks.  Between 2004 and 2006, $1.5 trillion (15% of  U.S. total housing loans) of high interest rate mortgages were booked.

These subprime loans were fine as long as the housing market continued to boom and interest rates did not rise. As house prices escalated, homeowners piled on more debt by taking out home equity loans, which reached a high of $700 billion or 5% of U.S. GDP in 2004.

So what brought this party to a halt? Housing markets go through booms and busts. The latest U.S. housing boom was fuelled by low interest rates and excess liquidity. The Fed dropped short term interest rate to 1% in 2003. Long term interest rates were low as countries like China and Japan accumulated huge trade surpluses and funded private and government consumption. In other words, emerging countries were financing the spending binge of U.S. consumers.

Much of private household debt was channeled into the housing industry.  The median house price jumped 40% to $234,000  between 2000 and 2006. The ratio of median house price to median household income rose from a historically stable ratio of 3 times (between 1970 and 2000)  to 5 times in 2006. This was not sustainable.  House prices tapered off and started to decline by 2006 and are expected to fall sharply in 2007. Concomitantly, default and foreclosure rates  rose. In 2006, 1.2 million household loans were foreclosed and is expected to double to 2 million this year. The default rate is expected to rise when 2.5 million  adjustable rate mortgages reset higher in the next 18 months.

So why should defaults and foreclosures of subprime mortgages in the U.S. concern or affect us?  First, financial and technological innovations in the past few decades have simultaneously globalized and shrunk the international financial system . The financial products associated with subprime mortgages have been distributed far and wide. Second, financial innovations, through risks transfer and dispersion, have lulled the players and regulators to accept higher level of leverage, and to take on more risks for the system as a whole, thereby increasing the volatility and fragility of the international financial system. Therefore, what started as a crisis in the subprime mortgage industry quickly generalized  into credit crunch for other financial sectors like private equity, leverage buy outs, conduits,  the commercial paper and money market systems. Thirdly, the decline in the U.S. house prices and industry will have serious effects on the real economy which will negatively affect the rest of the world.

One important financial instruments introduced in the eighties is the securitization of assets. Simply put, it means bundling individual assets together (these assets can be housing mortgages, student loans, corporate loans, car loans, etc.) into a security, such as a bond, and selling them to investors; hence the term asset backed securities (ABS).  This is also known as the  “origination-distribution” model. Securitization enabled banks, the originators of these loans, to take on more loans as they moved the securitized loans off their books.  It is supposed to transfer some of the risks away from the banking system to other parts of the financial system. But these risks did not disappear, they were just dispersed and amplified for the system as a whole as it encouraged more leverage and higher degree of risk taking. 

In 1990’s, financial innovation took these ABS to a higher level in terms of complication and leverage with the introduction of collateralized debt obligations (CDOs).  CDOs are simply the bundling of a class of ABS into a special purpose vehicle and then rearranging these assets into different tranches with different credit ratings, interest rate payments, and priority of repayment. An investor, depending on his risk appetite, can choose which tranche to invest in. The AAA tranche pays lowest interest rate but provides highest priority in terms of debt repayment. The volume of CDOs issued tripled between 2004 and 2006 from $125 billion to $350 billion per year. These CDOs were widely distributed. Not only banks but also staid establishments like town councils in far flung places like Australia bought these CDOs.  Bank of China has $9 billion of subprime CDOs. Two German state banks investing in CDOs went bankrupt and were bailed out by the government.

These CDOs resemble a house built on a deck of cards. When the cards begin to crack, the house falls apart. As subprime borrowers in the U.S. began to default, investors in the subordinated tranche of  subprime CDOs took the first hit.  This led to a loss of confidence even among investors in the safer tranches who have not yet experienced any loss.  As they head for the exit door together, this created panic and the sale of these assets led to a downward spiral of prices.

Compounding this problem is the fact that many originators of these mortgages engage in the classic strategies of leveraging and mismatch funding. These companies borrow on a short-term basis  (at lower interest rates) to invest in long-term assets (at higher interest rates and risk) in order to capture the differential in interest rates. This is profitable as long as short-term interest rate is lower than long-term rate. But when the former moves up more than the latter, a profit can quickly turn into a loss. This is exactly what happened to the savings and loans industry in the 1980’s.  The same thing occurred when Asian banks and corporations played the funding mismatch game. They borrowed in U.S. dollars at a lower interest rate and invested in local currency assets that provided higher yields.  The going was good until the dollar appreciated and many borrowers went bust. Today, this problem is haunting financial institutions that play this game, such as mortgage companies, conduits, and banks including those like Northern Rock who have no exposure to the subprime mortgages. Despite the financial innovations of the last two decades,  the underlying problems of leveraging and funding mismatch are repeated; hence old wine in new bottle.
 
The fall out of the subprime mortgage also affects the real economy.  Modern economy is essentially credit driven.  The total amount of debt in the U.S. as a percentage of its GDP  rose from 150%  in 1969, to 240% in 1990, to 340% in 2006. In volume terms, U.S. total debt stands at $45 trillion. U.S. economic growth has been 70% powered by household consumption which was made possible by the perceived increase in household wealth, consisting significantly of house ownership. U.S. consumers felt rich when house prices rose and took out home equity loans to spend. Now as house prices begin to tumble,  the reverse happens. Home equity loans shrink, consumer confidence plummets, and consumption declines. This could drag the country into a recession that could affect the rest of the world. U.S. consumption still accounts for 20% of the world’s GDP.  Some argue there is a decoupling of the emerging market economies from the U.S. It remains to be seen to what extent this is true.

The central banks of various countries have stepped in to support specific financial institutions, assist the ailing housing industry, and support the battered financial industry by pumping liquidity into the economy. Initially the stock markets were cheered. Then they went on a roller-coaster ride. Now despite the second rate cut by the Fed, the stock markets are still tumbling. There is historical evidence to indicate that such liquidity pumping serves to create another bubble down the road.  Some refer to this phenomenon as the rolling bubble. The U.S. Treasury Secretary, Paulson, a former Wall Street banker, warned that the problem is not short term but will be with us for a while.