Trying to understand the credit crunch
Over the past few days I’ve been thinking about how the credit crunch came about, so that I can understand what’s happening to the housing market. This is as far as I’ve got:
1. The credit crunch started because American banks expanded their mortgage market by giving loans to households at high risk of being unable to keep up repayments, due to low wages, insecure work, disability and so on.
2. The banks had two ways of dealing with the potential risks this incurs: first, they charge a higher rate of interest on these ‘sub-prime’ mortgages. Second, they sell on the debts to other financial institutions, including banks (the debt repayments provide cash flow). In some cases they parcelled up the bad debts along with less risky options. The financial institutions who bought these debts were based in various countries, including the UK.
3. People who should never have been sold mortgages in the first place started to default on their loans, not due to worsening economic conditions but because they were a bad credit risk. This is why the crisis could develop at a time when employment and inflation levels were not a particular problem.
4. The increasing level of bad debts meant that financial institutions had to write off more of the debts they had bought, and they didn’t get the anticipated cash flow from repayments, thus affecting their profits.
5. As a result, they became more cautious about buying debt packages, which meant banks were stuck with their bad debts and got into difficulties.
6. And they became cautious about any inter-bank lending and borrowing, thus restricting the amount of money available to borrow, e.g. for domestic mortgages, property development on a larger scale, or business loans. Northern Rock is one of the banks that can’t borrow from other banks, so it can’t lend more to improve its cash flow, and can’t sell on its bad debts.
7. Restrictions on mortgage finance for domestic house purchase lead to a reduction in the amount institutions are prepared to lend as a proportion of the borrower’s salary and also as a proportion of the value of the property: 100% mortgages, or more than 100%, are no longer offered.
8. Housing demand starts to fall, therefore prices fall.
9. Buyers don’t come back into the market to take advantage of lower prices because they can’t get a mortgage easily, most commonly because they don’t have the required deposit to make up the proportion of the value of the property not covered by the mortgage.
10. As a separate issue, energy prices start to rise, causing price rises generally and affecting the ability of potential housebuyers to save for their deposit; these households may also have other debts on which interest rates rise
11. Many households, not just potential housebuyers, cut back on their spending
12. The knock-on effect of both the credit crunch and higher energy prices start to impact on the wider economy. This is where we are right now. Unemployment should start to increase, although the current UK picture is more complex – the claimant count is rising, but unemployment is static as there are more people in the labour market than ever before.
So what next? Doing something about the decline in the housing market is regarded as crucial, although the Crosby report, commissioned by the Treasury to review options for government intervention, leans towards the do nothing option. We learn today that a stamp duty ‘holiday’ is a possibility. Although this would reduce the cost of moving, and therefore put a bit more money towards the deposit, it doesn’t tackle the root of the problem, which is the decrease in mortgage availability.
So should the UK government intervene in the housing market? Or in any other way? Or would it just be using taxpayers’ money to allow people to buy houses two years earlier than they otherwise would? I will return to this subject.
12 comments:
There are so many factors at play, Jenny, and my belief is that there are huge consequences coming for the way the markets and banks have been playing around creating false wealth and valueless real estate equity.
Our planet is so overloaded as to be on the breaking point. And the inequality of living is untenable.
the reality is that we will all have to simplify and accommodate this new paradigm which will be forged cataclysmically, some serious weather, disease, starvation, water deprivation, not to mention food shortages are looming every bigger on the horizon.
Mortgage assistance will be the least of our worries.
XO
WWW
www - although I agree with your last point, we all still need somewhere to live. In the UK and Ireland, housing is seen as a savings bank rather than a place to live, and having equity is necessary to move up to a bigger house. I wonder if we'd all be happier if we rented and were able to rely on a decent state pension being available for our old age.
What interests me about teh credit crunch is that it has come at the same time as the increasing visibility of the consequences of global warming, but is independent from it, being entirely about teh greed of mortgage sellers who were exploiting the poor.
I must say that don't look forward to having to live more simply, though....
Apologies for hijacking the comments to this post – but are you aware of the Belfast Jazz and Blues Festival being held this month? I don’t think it’s getting much publicity so I scanned a flier on to my blog for anyone who might be interested.
It might be a good way to take your mind off the credit crunch (c:
Hi, Dr A - interesting, thanks! Hope there are good audiences. I think it'll take a lot worse economic conditions before Belfast people stop going out to enjoy themselves - one reason why I like living here. But I see Starbucks is on the skids.
There should be a 3.5 between 3 and 4. That is: because of the manner in which the high risk mortgages have been packaged, financial institutions don't actually know what on their books has value and what is worthless. So they can't actually respond until they've done a massive forensic audit to figure out how much they've lost.
And there's no reason for thinking that we or they actually know the full story yet.
Also, on the high-risk customers, there' an interesting story to tell about what happens when head office gives you a target without paying too much attention to how it's attained (something the Irish encountered ten years ago with the DIRT tax). It seems many bank managers were not averse to sending people off to falsify their employment details and the like. So this isn't about people who were high risk being given mortgages. It's about the industry colluding people with or encouraging them to understate the risk.
It must be noted too that the banks sold sub-prime mortgages not to get low-income borrowers on to the housing ladder but from the greedy assumption that rising house prices would mean the collateral would be worth more than the mortgage so a profit would be guaranteed even, or especially, in the case of a default. The ratings agencies were complicit also in awarding these dubious asset-backed securities with AAA ratings, thus there was an incentive for them to be traded on the global financial markets.
Then there is the lesser-discussed issue that the West itself, let alone sub-prime borrowers, has been living on credit from Asia as the once debtor nations are now our creditors.
Ciarán - Your first point - yes, I deal with that slightly in 2, but not emphasising that the banks didn't actually KNOW where the bad debts were - and as you say, that's scary. Banks are now starting to report heavy losses - Barclays yesterday, RBS today.
2nd point - 'this isn't about people who were high risk being given mortgages' - well, ultimately it is, but the collusion is important - as you say, it's about targets, but it's also about what the alternatives to home ownership were for these groups. They may have been misled, but also I'm sure some thought they would take the risk. So in the end, someone else has to say 'you can't afford it'.
nineteensixtyseven - welcome! Of course you're right that sub-prime mortgages weren't sold out of charity - that point about asset-backed lending is important. So the banks thought they couldn't lose even if they didn't sell on the debts. It's also an interesting point about ratings agencies. I presume you're talking about the USA, but I've heard here that even highly rated borrowers can't get loans now. But it also links in with Ciaran's point about the banks not knowing what they were buying.
And thanks for the point about Asia, which again I hadn't thought about.
I'm learning a lot from this post!
I wonder if the gvt really wants to intervene in the housing market? I think the big unsayable issue is that they want house prices to come down, down, down. And tbey can't admit this to voters.
Take a look at this Bank of Ireland graph comparing rising house prices in NI against the Retail Price Index.
Recent increases have been insane - and totally unsustainable. Prices need to come down substantially (20 to 30%) if the UK market is ever to get back to 'normal'.
This is going to hurt a lot.
But the grim truth is that it's going to hurt a generation who were in the processes of passing these huge housing costs on to the next generation. They/we haven't got away with it - house prices may well return to normal - and our children may be the ones who benefit.
Anon - I shoudl have worded the last paragraph differently. The governmetn already intervenes in teh housing market in various ways, the question is whether they want to change that intervention. Levels of stamp duty, interest rates, capital gains tax on 2nd homes, (in the past) mortgage interest tax relief, and of course public money going into social housing (including co-ownership) and regulation of the private rented sector, all make particular tenures more or less attractive at any one time.
The barker Report in England a few years ago said that more houses needed to be built in order to stabilise supply and demand; as an economist, her view was simply that more houses on the market woudl mean lower prices. But one thing we really don't know about our housing market is how elastic it is - on the one hand, the extent to which people will be prepared to wait to buy e.g. rent or live with parents; and on the other how much 2nd home ownership will become the norm for the middle classes.
So yes, the baby boom generation (yet again) has done well with the free good of housing-based capital gain, but as you say it has been at the expense of younger people.
Jenny,
A book I think you might enjoy from reading this post is "The Gods That Failed" by Larry Elliott (Guardian economics editor) and Dan Atkinson (from the Mail on Sunday but don't let that put you off). It sets out the charge that deregulated finance has failed and give numerous cases covering all different aspects of the sector's failure since it was deregulated a few decades ago. I have no formal knowledge of economics and know only what I deduce from reading financial pages and commentaries in papers and magazines, so I struggled with some of the more difficult concepts, but it was easy enough to follow their general arguments. It's very recent (June I think) so it has the sub-prime crisis in detail, notes on Northern Rock etc Really good.
Thanks for this, 1967, I have ordered it. Perhaps this comment links with your point on the previous post about a centre left alternative to Milliband?
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