Lending for Dummies

Mike Hornbrook:
The Great Subprime Panic of 2007
How the meltdown went global
August 13, 2007

What we are witnessing around the globe could be the 21st century equivalent of a run on the banks. These days, advanced economies are not saddled with the creaky accounting and hyper-restrictive monetary policies that triggered the Wall Street crash of 1929. But the globalization of banking and money markets means that when a big economy like the U.S. sneezes, the rest of the world gets a cold and some countries will even catch pneumonia.

The beginnings of the crisis are in the U.S., but what has now started to take place is an attempt to head off a global epidemic.

Right now, there's a great deal of nervousness in global markets about how much bad international debt is being propped up by dodgy subprime U.S. mortgages, the pepper behind the sneeze.

First of all, what is a subprime mortgage? In general, this describes money loaned to people who wouldn't qualify to borrow, or borrow as much, under normal circumstances. A study by the Center for Responsible Lending — a U.S. nonprofit group — says most subprime borrowers are not buying a house but refinancing debt, usually credit card debt.

They tend to live in low-income neighbourhoods and are less likely to have a college education. Only about one in ten subprime borrowers have the assets or the credit history that would qualify them for a prime loan.

Subprimes represented about 20 per cent of the $3-trillion US mortgage market in 2006. It is this segment where defaults are now occurring. The scale of the problem is far from clear, but one recent report said 97.8 per cent of all U.S. mortgages are being paid on time and are not in arrears.

How some U.S. mortgage defaults affect many economies
The nature of modern finance is to disperse risk as widely as possible. Hundreds of billions of dollars' worth of subprime mortgages have been gathered together and resold as bonds to hedge funds and banks all over the world. The buyers then used them as collateral to secure more loans so they could buy more bonds and so on and so on.

It was all sustainable during the days of soaring house prices and easy credit. But when U.S. interest rates began climbing and house prices started falling, then the default rate edged up and the subprime business hit a wall.

This became shockingly apparent last week when the giant French bank BNP Paribas had to suspend activity in three of its hedge funds that were heavily invested in subprime-backed securities. The dire news about a growing subprime contagion scared off investors. The bank, literally, couldn't give away its bonds. With no one buying, Paribas was unable to realistically price the bonds in normal trading, and so it put an "out to lunch" sign on the fund-redemption window.

It's a little like listing a $300,000 house for sale on Tuesday. Then on Wednesday, after newspapers report the house sits on a toxic waste site, the house suddenly is worth nothing because no one will buy it.

Investors head for the exits
In markets around the world, investors in subprime-backed products are heading for the exits. Bank-owned funds are being forced to limit withdrawals because they can't price the products properly. This has dried up liquidity and for a few days last week drove overnight borrowing rates between banks sharply higher on four continents.

Central banks in Asia, Europe, the U.S., Canada and Australia responded by injecting hundreds of billions of dollars into their country's money markets. They did this by making money available to banks at a special interest rate at, or very close, to the rate commercial banks charge each other. In this case, it had the effect of reducing a rate spike that threatened to soak up liquidity. Most of the central banks also said they were ready to provide whatever funds were necessary to keep bank activity going.

By law, banks have to maintain a certain percentage of their deposits on reserve. Anything above the legal requirement can be used in inter-bank transaction settlements. Banks with surpluses loan money to banks with deficits at a special bank "rate". A lack of liquidity is destructive because banks stop lending and that means the effects are felt throughout an economy.

The central banks hope the injections will calm the markets and head off the destructive effects of a credit freeze. Yet in some countries, the move only accentuated the panic. Investors were saying, in effect, "If they're taking this unusual step, what do they know that we don't?"

Diagnosing the subprime contagion
There's widespread suspicion that the contagion from the subprime mess may run wider and deeper than previously thought. In part, that's because no one yet knows how much debt is sitting on the quicksand of subprime mortgages. And no one knows which banks and hedge funds are holding securities based on the mortgages.

Small wonder stock markets everywhere are volatile. This week will likely bring more volatility as a global credit correction continues to shake out in all major economies.

Though no one is predicting the kind of devastation that occurred in the U.S. when Wall Street crashed in 1929, what we will likely see is a psychological change. After years of free spending financed by easy credit, we are entering a new era when it's going to cost more to buy a home and finance a leveraged buyout. And that will put a giant brake on a lot of economic activity.

Just another full iteration of the Greed Cycle. It has happened in the past (remember the S&L scandals of the early '90s?), and it will definitely happen again. The question is how deep does this pile of shit go, how pervasive will it be across the global economy, and how much of it will spill into the legitimate banking and lending industries?