Wednesday, November 19, 2008

A primer on subprime (2 of 5): Why governments had to bail out the banks

The virtuous cycle was trundling along. The economy was doing well (thanks to consumers spending on borrowed money), asset (house) prices kept increasing which meant default rates hit all-time lows as even the sub-prime borrowers were able to either flip their houses or service their loans at the low rates. The low default rates made financial institutions even more confident and they offered increasingly attractive loans to consumers.

At the peak, banks offered “No money down” mortgages and arrangements such as ARMs (Adjustable Rate Mortgages). ARMs allowed borrowers to pay very low interest rates for periods of two to three years. After that, market rates would be charged and principal repayments also started, but borrowers were convinced that by that time property prices would be higher. They would just sell their property, repay what was necessary and still reap a healthy profit.

Some alarm bells were raised. Some pundits suggested mortgages were increasingly being offered to people who couldn’t afford them. But regulators, lead by Alan Greenspan, said markets had found new ways of dealing with and pricing risks and there was no systemic problem (ie individual institutions that took on too much risk may go under, but the entire financial system was robust)

With hindsight, Greenspan was proven hugely wrong at enormous cost to the taxpayer. All good things must come to an end, eventually.

There are only so many people and so many potential housebuyers. After years of scraping the bottom-of-the barrel for the marginal borrower, to the point where lenders closed one eye as borrowers over-stated their incomes so they could go for bigger mortgages, there were no more new borrowers to be found. No new borrowers meant reduced demand for properties, which meant asset prices started to fall.

The house of cards started unravelling. Default rates on the CDOs turned out to be higher than expected. Even AAA-rated CDOs turned sour. Not surprising – considering the mortgages on which these CDOs were based were given to consumers with poor credit histories or to consumers who could not afford them.

Wait! Weren’t some CDOs backed by credit default swaps (CDS)? The CDSs turned out to be not worth the paper they were printed on. The institutions that were supposed to pay-up were woefully under-capitalised!

The problem was made even worse by the absence of open markets for these CDOs. These were traded over-the-counter with valuations based on complex mathematical models. But investors had lost faith in the assumptions going into the models so values could not be determined with certainty.

Also, it turned out that the banks were also liable for some of these CDOs. To entice investors to take the CDOs, the banks had agreed to buy back at least some of these if default rates turned out to be higher than expected. No-one expected the default rates to be that high, but when they hit that level, the banks had to buy back, incurring losses.

This lead to inter-bank credit markets freezing. Any bank, on any particular day, could be a net borrower in the inter-bank market. It is not bad management, it is just a matter of cash flow. For example, a company the bank had already approved a huge loan to draws down that day. The bank knows another borrower is due to repay tomorrow, but in the meantime, it has to borrow today to cover the gap. Tomorrow, when a loan is repaid, it may become a net lender in the inter-bank market.

But the inter-bank market froze. Banks became reluctant to lend to each other as they could not tell if the other bank would still exist tomorrow. Imagine if you were the bank lending to Bear Stearns or Lehman the day before they went under!

Initially the US Federal Reserve and the European Central Bank tried to restore the inter-bank market by making funds available for banks to borrow on more favourable terms and cutting interest rates. This did not help: 1) Banks were unwilling to take Federal funds because it would indicate weakness; and 2) cutting interest rates did not help because it did not address the core issue – banks were unwilling to lend to each other at any price.

The financial problem was turning into a real economy problem. Because banks could not tap the inter-bank market to cover short-term cash shortfalls, every bank wanted to be net cash. They started cutting back on loans to companies and individuals. In turn, companies and individuals would also want to hoard cash. The curtailing of credit facilities threatened the foundations of the economy – business activity would slow leading to job losses, bankruptcies and recession.

British Prime Minister Gordon Brown in the end got it right. Contrary to his long-held views, he extended government backing to the banks. This led to a flood of central banks around the world, including Malaysia, to guarantee deposits. With government guarantees, banks became willing to lend to each other again and credit markets were restored.

Next on Saturday: Brace for tough times

1 comment:

Jed Yoong said...

Gordon is good with the economy. ;)