Wednesday, September 10, 2008

Credit Crunch: 1. Preamble

I am often asked to explain the credit crunch crisis in terms that can be easily understood. My various answers to this are the subject of this blog and subsequent posts.

I begin with a macro view, the big picture that looks beyond banks and financial markets for reasons why, but without ignoring the central role played by banks (by which I mean banks, mortgage brokers, investment houses, hedge funds, and all institutional investors).

Alan Greenspan (ex-Chairman of the Federal Reserve) says the credit crunch (also called the US sub-prime crisis) has non-financial sector origins. By this he means that easy credit for mortgage loans and consumer spending using credit card loans were not only a responsility of the banking system. The USA and UK Governments both looked to the banks to fund mortgages for the poor as an alternative to government funded social housing. Public sector house-building reduced to almost zero and public sector housing stock has been massively reduced by selling to tenants and to private housing associations.

The US and UK 'Anglo-Saxon' 'credit boom' economic growth of the last 20 years has been also variously copied by other countries such as Australia, Ireland, Spain, Denmark and Greece. The common essence of this is 'endogenous', or internally generated, economic growth (high spending, high debt and low unemployment) fed by soft loans and rising property prices, but at the cost of historically high trade deficits, especially that of the USA, which allowed many other countries to gain export surpluses as the main source of their economic growth such as China, Brazil, India and the oil producers ('exogenous', externally generated). But, trade deficits have to be financed just as trade surpluses have to be invested in foreign currency financial assets (mainly US dollar), and when governments are not issuing debt instruments, it has been up to the banks to create financial assets to sell to the export surplus countries.

This is best understood by appreciating that the present crisis has its origin in an extreme imbalances in world trade whereby the credit boom economies (overwhelmingly the USA) financed unsustainably high net import bills by selling net financial assets. The trade deficits were led and paid for by the credit boom packaged into $ trillions of financial asset backed bonds (ABS) and collateralized debt obligations (CDO) offered for sale, directly and indirectly, to net exporting countries. It is noteworthy that since the credit crunch and the creation of new net financial assets for sale has dried up (or the buyers have) that this year China's growth is 60% endogenous (domestically generated) where it was previously 90% exogenous (externally demand-led) and the USA's growth is 90% export-led. This is a massive reversal in the trend and pattern hitherto of trade and payments. Such dramatic change will however not be without cost (topic for a later blog post).

Economists and central banks worried and issued polite warnings about this fast-growing trend for years. The economists warned that the extreme trade deficits and surpluses, with international trade growing several times faster than world GDP (profits plus employment earnings), were not sustainable for much longer and must lead to a dramatic collapse in the present pattern of international trade and payments. Cetral banks issued stability warnings and advised banks to diversify away from mortgages towards more lending for manufacturing and other export sectors. Central banks also warned that rising consumer and household debt levels could not continue and that the markets in ABS and CDO are new and untested by market falls.

Governments and banks in the credit boom economies ignored these warnings. Governments were loath to rein in bank lending and consumer spending. They had various reasons for not doing so, not all of which were bad or self-serving reasons. Banks ignored the warnings for entirely self-serving reasons, to grow their global market shares and to maintain their short term profits. Banks had also significantly changed their business models. They shifted from servings customers to speculating directly in financial markets, and from matching retail lending with retail deposits to selling off their retail books (as assets and receivables backed bonds) so as to rapidly gain new funds to grow their retail lending volumes (mortages and consumer credit) much faster than the underlying economies were growing.

Full service commercial banks consist of two books of loans and deposits (also called assets and liabilities). These are the Banking Book and the Trading Book. The Banking Book essentially covers retail loans and deposits and longer term corporate loans and deposits, including deposits from other financial service firms. The Trading Book includes short term assets and liabilities that are held for trading in the financial markets, and can include loans to large non-financial businesses (conventionally referred to as 'corporates'). Essentially, the positions in the Trading Book should consist of 'financial instruments', which means assets and liabilities that can be traded in stock exchanges (including derivatives and commodities exchanges) or in the 'Over The Counter' (OTC) markets that do not transact through regulated exchanges, such as all of foreign exchange (FX) and most of money markets and bonds trading (together called fixed income).

The packaging up of retail assets in the Banking Book into bonds, a process called secutitization, allowed parts of the Banking Book to be transferred to the Trading Book and offered for sale. When central banks warned about the imbalances created by too rapid growth in mortgage and consumer loans, the retail and mortgage banks and the retail sides of 'full service' or 'universal' banks responded by holding down the size of their banking books only by securitising and selling off assets to and via the Trading Book, that is to say, from the retail side to the investment banking or wholesale markets side.

Investment Banks (and the investment banking sides of universal banks) did not heed the warnings because they viewed the securitised assets as instruments held for sale on their trading books and therefore by definition something they could get rid of quickly, believing that a truly liquid market existed that would buy these at a reasonable price at any time. All failed to see that ABS and CDO markets were more like primary markets where the instruments could be sold once, but that there did not yet exist a reliable and proven truly liquid secondary market.

Once the first round investors decided they needed to sell what they had bought, for the reason that popular fears grew about mortgage defaults and the prospect of a recession looming, and then found there were no ready buyers except at unprofitable discounts, the prices of these instruments fell rapidly; the market bubble collapsed. In large part this was because the ABS and CDO and related derivative instruments were too varying in their detailed terms and conditions. They found they had not invested in what financiers like to call 'plain vanilla' investments. Despite the trillions of dollars involved, the instruments were not all of a standard type; not commoditised. Many holders of these securitization assets could not afford to hold on until maturity. They had used short term funding to buy the securitized financial assets and now could not recycle their loans or meet the 'margin calls' (deposits demanded by their creditors as additional collateral for the loans they borrowed).

Up until these new, yet very large, markets in packaging and selling financial assets were tested by the first price falls, there was a sanguine view among banks that the scale of this business was so large, and so many banks involved, that the market could not catastrophically fail; modest falls perhaps, a necessary correction maybe? A similar quality coloured the political consensus that as long as prosperity and unemployment are up and trade deficits can continue to be financed somehow, no major corrective action is needed to rein in the credit boom.

Many commentators, such as the FT's Martin Wolf, blamed governments and central banks for too loose monetary (and lax fiscal?) policy. The Bush administration was full of hubris on all fronts. It has to be doubted if the biggest banks could have been persuaded by financial regulators to slow their growth (and their efforts at the same time to grow globally) when political leaderships of the credit-boom, import-deficit economies took heart from the fast growth of their banks (especially USA and UK) and who began to think the power of financial services to be more important than physical trade and manufacturing.

Central banks and regulators (and macro-economists) needed stronger voices in government as much as among the banks? The current crisis is at least as much a failure of macro-political-economics as it is a failure of banking regulation!

The main focus for new banking regulation to stops the banks from over-reaching themselves is called Basel II. It is thousands of pages of precise prescriptions, rules and principles with the force of law to force banks to think more comprehensively for themselves about economics contexts and be more circumspect about following their own herd instincts. Basel II had olnly been half implemented by the time the credit crunch crisis unfolded (beginning in August 2007, although the strongest warnings had begun in late 2005 and should have been crystal clear to those willing to listen by the beginning of 2007.

In the context of the credit crunch, when interbank financing dried up, Basel II's failure is merely that it was not completed ahead of time, before the crisis broke. Some may argue that the regulation is only akin to a white picket fence astride the path of a thundering herd of Wildebeest. I disagree. But, all may agree that insofar as the credit crunch and recession conditions are partly, if not wholly, avoidable as disasters, ultimate blame lies with political management as much as financial management.

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