The Banking Crisis

The recent moves by the US Federal Reserve to keep the economy from going into recession have seen interest rates cut from over 5% to 2.25% in just 12 months. This has largely been led by big falls on the stock markets after the collapse of credit availability. The problems caused by easy credit and low interest rates 3 years ago have resulted in widespread mortgage defaults and foreclosures, which has, in turn, resulted in the collapse of credit availability. The truth about the sub-prime mortgages was never delivered at the point of sale, that these mortgages would be anything up to 5 times more expensive once the introductory discounted period finished, and this has resulted in billions of Dollars being wiped out as bad debt.

The banks, bond insurers, hedge funds and SIV’s (Structured Investment Vehicles) that are now suffering from these losses are largely responsible for causing this situation by allowing the selling brokers of these mortgages to gain a triple ‘A’ credit rating through their backing from the big banks Credit Default Swaps, and this has seen the very high risk debt they were selling, also gain the triple ‘A’ status. This has now created two big problems that are stopping banks from lending to each other.

Firstly, they are unable to distinguish between good mortgages that have been taken out by people who are able to service their payments, and bad mortgages taken out by people who are unable to service their payments. By enjoying selling every mortgage as triple ‘A’ secure in a CDO bundle, they have diminished everyones ability to separate the good from the bad.

Secondly, the way in which mortgage debt has been allowed to be sold as a commodity to hedge-funds, SIV’s and banks means that as customers see the losses not only wiping out investment growth, but instead the whole investment, they begin to pull out their money altogether. Now banks are not just afraid to lend to each other, but have to use what little cash they do have available to service their own debts.

The problems of banks not being able to service their debts has taken out the two weakest businesses in the market; the Northern Rock in the UK, which had a poor business plan with no recession fallback capital, and Bear Stearns, who got too carried away with business growth based on sub-prime debt.

For the rest of the banks this now means that the billions of dollars the Federal Reserve are making available are not being used to reduce the rate of foreclosures, but instead are being used to payoff investors who are pulling out faster than the banks can liquidate the properties they have invested in.

When merchant banks such as Morgan Stanley, Lehman Bros. and Goldman Sachs are involved in bankrolling the sub-prime mortgage markets and hold these debts off the balance sheets, having sold mortgages that were clearly never going to be serviceable after the introductory period, should they then be propped up by the Federal Reserve with lower interest rates and billion of Dollars in finance capital? I would like to say no, but can see why they have said yes.

The markets taught the world that when you lose your investment you have lived by the sword and died by the sword, and that’s just how it is. So when it comes the merchant banks turn to go out of business for the obvious mistakes they have made, all the swords seem to have been headed off by the Federal Reserve. This works against one of the core principles of economics, the ‘Moral Hazard’, which states that if companies make foolish mistakes (in this case worth billions of dollars), then bailing them out as the Federal Reserve has creates a consequence-free environment of operation and they will not only fail to learn from these mistakes, but are very likely to make them again and again.

The merchant banks (or big banks) that only lend to big companies and governments are seen however as a special case because their collapse would be too big for the world economy to handle, and so have been allowed to apply for extra funding for their businesses. The big problem is that this money isn’t on its way to the mortgage customers who themselves would like the Federal Reserves help, instead it goes towards helping these big banks service their debts and paying the Golden Parachutes of all the senior board members who have been forced to resign because of their greedy and foolish mistakes.

The US Housing Market Problem

This is the situation as I see it: The economies in both the US and UK have enjoyed the longest periods of stability and growth ever recorded and have enjoyed a real boom. The big problem with that boom is that since around 2003 this has largely been based on borrowing that should never have been allowed. The moves by the Federal Reserve in setting interest rates down to 1% by 2005 allowed too many customers into the market, and made the cost of borrowing too cheap.

This move by the Federal Reserve to set interest rates low to stimulate growth in the economy did just that, but unfortunately, combined with poor regulation in the banking sector, that allowed mortgage lenders connected to banks to gain AAA lending status (the same as the banks of England), which resulted in a situation where customers with poor credit ratings could afford mortgages that were not properly risk-assessed and instead were seen as triple ‘A’ secured debts.

This had now created the perfect conditions for a housing boom where excessive demand led to an increase in every property’s value. This led to two destructive scenarios; customers selling up and trading up to a bigger homes with cheap mortgages they could afford for the initial introductory period, or banks offering customers the chance to increase the lending on their homes because the mortgage they had was only worth a fraction of the houses new value. These Equity Release Loans (or second mortgages) could then be invested in anything from holidays to renovations on the home, further increasing the value of the property and allow the owner to release more money from lenders, or trade up to a bigger home.

This cycle of lending was always going to end badly as its continuation was based on a constant level of high demand, which, in turn, created the constantly increasing prices. The big problem with this scenario is that at some point the demand will begin to fall and then so will the house prices. Demand will fall because cheap lending creates inflation (known as demand pull inflation) which is countered by increased interest rates ,which then removes cheap lending. At this point the Adam Smith effect of the invisible hand of the market kicks in, and the whole scenario is thrown into reverse with house prices returning to a more appropriate value for a property. This change is currently taking place in the US housing market, with everyone waking up together (banks, lenders and customers alike).

The problem that is left in the wake of this cycle is devastating. Customers are faced with mortgages they can’t afford and go into foreclosure, prices are still too high for first-time buyers to join the market and the loans available are too expensive to afford, so demand is further depressed.

The big sell begins with people unable to afford their properties now looking to sell, which results in far too many properties put onto the market at once, which further depresses values. In many cases customers are now in the negative equity trap paying for high value mortgages that are now worth more than the value of the property. If your bank is kind enough to allow you to sell the property at less that you paid for it, you are left with no home and have to keep paying back a loan on the loss you just made when you sold your house. If the bank forecloses instead then you are again left with no home, but this time the debt is for the full value of the home. As a regular salary or wage would not even cover the interest payment, and the debt will therefore only increase, declaring bankruptcy is often the only solution.

The main problems now are that with foreclosed properties being put on the market for sale by the banks at quick sale knockdown prices, customers not yet behind with payments but that need to sell up and reclaim the value of their homes before they get behind, can’t sell their homes because there are too many houses for sale to compete with, which keep dropping in price.

As is now evident in the US, the economic binge created by cheap credit has reached as far as the lending can reach, and the reality of poor choices at the top is being felt by the people on the ground.