World still paying for easy credit glut five years on

03 April 2012 - 02:11 By David Shapiro

It's nearly five years since evidence surfaced that the US housing market was heading for a disastrous downturn, an event that proved to be the prelude to a devastating decline in the investment banking industry, and the onset of the credit crisis and recession in the global economy.

In the second quarter of 2007, losses in two major structured funds that were exposed to the subprime housing market, and managed by influential bank and brokerage house Bear Stearns, began to mount, placing severe strain on the firm's finances. After desperate efforts by the Federal Reserve of New York to keep the bank afloat failed, Bear Stearns was sold to JP Morgan Chase at a fraction of the price its shares had been trading at a few months earlier.

Loose fiscal and monetary policy in the previous decade, along with a savings glut in Asia, capital from which found its way into the US, had allowed Americans to live beyond their means.

Interest rates were historically low, reduced by the Federal Reserve in an effort to bolster confidence, which had sunk after the collapse of the internet bubble in 2000 and the terrorist attacks against the US in September 2001. The banking industry was flush with cash and eager to find reasons to lend.

In the late 1990s the Clinton administration had encouraged government-backed agencies such as Fannie Mae and Freddie Mac to make homes affordable to low-income groups. Given the nudge, mortgage lenders, having exhausted middle-class demand, started tapping into borrowers with no income, no jobs and no assets.

Between 1997 and 2006 explosive demand pushed house prices in the US up more than 100%, and home ownership increased from around 65% to 70%. The warning signs were clear. Residential property prices rose from three times the average wage to 4½ times. More than 20% of new mortgages were issued to the perilous but burgeoning subprime sector. On top of that, homeowners began cashing in their new-found wealth by refinancing their mortgages and using their gains to buy either second homes or simply to splurge on consumer goods.

Subprime risk entered the banking system through securitisation - the bundling of mortgages into suitably tailored products that issuers passed on to an investment community eager to offset low yields on government debt. The dangers were exacerbated by the repeal of the Glass-Steagall Act in 1999 that had permitted banks to increase their gearing ratio to as much as 30:1. Banks, ignoring the heightened risk embodied in these toxic assets, stuffed their balance sheets.

Ballooning household and bank debt were delicately hinged on the direction of property prices and when the Federal Reserve began raising interest rates in 2006 to more normal levels (from 1% to 5.25%), to dampen inflation, the whole financial system began to unravel; slowly at first but then at an uncontrollable speed.

Home prices declined dramatically, impairing the value of securities on banks' balance sheets. Soon, banks, fearing insolvency, stopped lending to each other and to their customers. Finally, when one of the top five investment banks in the world, Lehman Brothers, declared bankruptcy in September 2008, owing about $600-billion, the US government was compelled to intervene, using taxpayers' money to restore equilibrium.

The crisis was not confined to the US. There were similar property booms in Ireland, Spain, France and Australia but generally domestic banks in these countries, unlike in the UK and US, were cautious in the use of innovatively structured debt products.

The failure of Lehman brothers raised deep concerns about a collapse in global demand, triggering a rush for the exit in commodity and stock markets that brought the world economy to the edge of a precipice, exposing as well structural weaknesses in countries such as Iceland, Greece and Spain, and corporate frauds such as Madoff.

Five years down the line we are still paying the price of the glut of easy credit, the technical malfunction of risk-management models operated by the world's largest investment banks and the irresponsibility of government authorities who did not understand and correctly regulate the risks posed by financial innovation.