The Credit Crunch - Why it Happened

We have all been witness to some pretty incredible events over the last couple of months that appear to have generated a new phrase in our language, "The Credit Crunch". We can see the effect in the failures of our financial and retail institutions but the question of why it happened, and what we can learn from it, seems less clear.

In December I was sent a link to a seminar given at Harvard University on the 25th September 2008 called "Understanding the Crisis in the Markets" in which a panel of experts from Harvard University do their best to get to the bottom of the problem.

Presenting the seminar was a panel of six experts including; Jay Light the Dean of the University, Rob Kaplan a Professor of Management Practice, Elizabeth Warren a professor of Law, Greg Mankiw, a professor of Economics, Keneth Rogoff a professor of Public Policy and Robert Merton a winner of the Nobel Prize for Economics.

The genesis of the problem appears to revolve around a phenomenon called leveraging. Briefly, if I own my house then it has a value. I can realise that value by selling the house, but then I would not have anywhere to live, so I have to buy another house and have not really achieved anything. Or I can take out a loan against my house, then I will have somewhere to live, and the money. I have leveraged my house. As long as I am able to continue making the payments on the loan the system works.

The breakdown in the system, as described by the panel, started as early as 10 years ago in the United States when mortgage brokers became tired of the boring old system of carefully assessing peoples ability to repay mortgages and instead started to look for ways that they could make more money from their sale. One of the ways they came up with was what was called a "Teaser" rate in which the sale of a mortgage was assessed on the ability of the buyer to make payments on a low introductory rate which lasted typically two years, and not on their ability to pay the other 28 years of a 30 year mortgage, at double the teaser rate. At the same time the mortgage companies were spreading their risk around other financial institutions by repackaging and selling their mortgage-loans to them. They were therefore less concerned about buyers defaulting on their loans when the higher rate kicked in because they were no longer lending their own money.

With more money available house prices started to increase and this led to the ratio of average house prices to average wages rising in America from something like 2.8:1 to over 4:1. In the UK that Ratio exceeded 6:1 as house prices rocketed and the mortgage companies looked for new ways to sell mortgages.

This was not sustainable in a flat market, but the world was in growth, corporate profits reached record margins, property prices were increasing and the market was being sustained, for a while.

Meanwhile wages were stagnant in real terms while living costs continued to rise, making it increasingly difficult for homeowners to make ends meet. For many the only way out was to take a second job. Then the homeowners discovered their ability to remortgage, or leverage, their homes to release their capital.

While property prices continued to increase this was fine because when the teaser rates on the remortgage ran out the property had increased in value sufficiently to remortgage again. This release of capital masked the fact that middle class America was having an increasingly difficult time funding their lifestyles from their wages.

A point to note is that the perception of these "Sub Prime" mortgages is that they were supplied to the poorer sections of the community to get them on the housing ladder. In fact over 80% of these loans were remortgages sold to existing borrowers - the home owning American middle class.

Then house prices stopped rising.

Now when the teaser rates ended there was no more equity to be released and the homeowner was left with a huge debt and no way to pay it off.

In the meantime the mortgage companies, well aware of the problems they were stacking up, had spread the risk of their loans throughout the financial community by taking out loans on their loans, or leveraging, so that ownership of the mortgage was spread around in a very complex way that only works in an expanding market, or while the release of equity continues to fund expansion,

When the release of equity dried up nobody could afford to repay their loans. Not the house owners, nor the financial institutions.

The complex relationships of the worlds financial institutions and the global nature of their business has ensured that these effects are being felt around the world.

The discussion finished with questions from the floor, one of which suggested that the current crisis might be dwarfed if the problem of over leveraging is not solved before the next round of Teaser mortgage rates expire.

The panel of six experts agreed that the answer was not going to be easy to find.

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