Mortgages and The Credit Crisis. Special Report

NOTE: this is included here for historic interest

What is happening and how does it affect you

Basically Banks have stopped trusting each other. This matters because it means they aren’t lending each other money which means there is a “liquidity crisis”.

This affects normal people like us because banks and building societies can’t / won’t lend as much to consumers.

After increasingly liberal lending over the past decade or so, they are reverting to old conservative attitudes. So mortgages, credit cards and personal loans will probably be more difficult / expensive to get.

What is the back ground to the Credit Bubble / Crisis?

The problem started with banks creating ever more complicated “lending instruments” which they used to trade between themselves.

These lending instruments, which enjoyed various fancy names like “collateralised debt obligations“, are a way for banks to buy and sell “packages of debt” amongst each other.

So far, so boring…

The problem was how these instruments were made up. Debt is usually secured against something.

In the case of mortgages your mortgage debt is secured against the value of your property. If you default on your mortgage payments the bank simply kicks you out into the street and sells your house. That is how they get their money back.

But here’s what happened with the “lending instruments”.

Let’s take two banks, that have no resemblance to any person, living or dead. At all.

The first one, the Bank of Overpaid Suits might have said to their buddies at the Bank of Humour Bypasses; “we have lent X million groats. This is secured on Y million houses. We don’t want to have to wait for 30 long winters to see all the debts repaid. Would you like to buy it from us for some upfront cash?“.

The Bank of Humour Bypasses gets a couple of smart kids to look through the figures. These kids are just about the only people who begin to understand what the heck is in the “instrument”. The kids give it the nod and the bank agrees to buy it. But the problem is that later on the Humour Bypasses realise that the property the debt was secured against is not worth as much as they thought.

This is basically what has happened with the sub prime mortgage and loans crisis in the US.

For a variety of reasons, particularly the insane need to please shareholders by making ever bigger profits every year – or you’re fired – the banks started lending to people who could not only not afford to buy a house – but would never be able to afford one and so should never have been lent to.

The problem was that these poor people were offered all sorts of attractive sales-trick discounts which meant they didn’t have to pay much money for, say, the first couple of years.

The sales people who convinced these poor rubes they could afford their very own homes had got their commissions and long since disappeared by the time the real monthly repayment levels kicked in.

And surprise, surprise, a lot of these poor folk couldn’t meet the repayments and had their homes repossessed.

What none of the incredibly clever “masters of the universe”, who run the financial institutions involved, seemed to realise was that when you start repossessing houses in a big way, the value of property tends to fall – in a big way. And if that happens then loans secured against property are suddenly worth a lot less than had been thought.

The major failure occurred with the credit ratings agencies like Standard and Poor and Moddys. These firms were paid by the banks to grade the reliability of the loans. They gave top AAA ratings to many packages that turned out to have been worthless. So it wasn’t all the fault of the banks. But frankly everyone should have known better…

So as the banks were trading their clever “instruments” among each other, and the penny started to drop, it seems the clever ones who had got it first started playing a game of pass the parcel.

The banks soon realised that they couldn’t trust each other and stopped lending to each other. This is why Northern Rock got into difficulties. It relied on borrowing money from other banks. But that dried up.

More recently, the seventh largest investment bank in the US, Bear Sterns basically went bust when no other bank would lend them the price of a cup of tea. They were “rescued” by another bank – But that’s another story, and probably one of only several to come in the next few months.

Idle question: What happened to the lesser spotted “Moral Hazard” – the idea that regulators should not bail out idiots, or there would be no reason future idiots should worry about acting recklessly?This phrase was heard quite often in the early days of the credit crunch. But it seems to have flown out the window as the crisis gained pace. The problem now is that unlesss teh authorities do something the whole system might implode. So much for the free market…

What’s happening now?

Well just read the news my friend !

This has turned into one of the biggest stories of the last several years.

Here’s what we wrote in March, for the record

At the time of writing, in late March in the year of our Lord 2008, the good ship western capitalist system is sailing blindly into a fog. No one is sure what is going to happen. But a few of the older sailors on board are shouting something about rocks.

Some commentators are talking of a huge, unimaginable crisis where the entire investment banking system will collapse.

That’s not great for people who work in them, but would that be such a bad thing for the rest of us? Consider this:

“…there’s a common thread linking all the major UK mortgage lenders that have been worst hit by the credit crunch. Northern Rock, Alliance & Leicester and Bradford & Bingley were all mutual building societies that, in the dying days of the Conservative administration, decided that floating on the stock market would give them access to “crucial” extra capital…. it doesn’t have to be this way.

Take a look at Caja Madrid, a Spanish savings and loans provider which must annoy the hell out of the investment banks as it is not quoted on the Madrid bourse. It has grown into the fourth-largest financial institution in Spain, and virtually all its profits – which, in 2007, were more than £2.1bn – go to the Fundacion Caja Madrid, dedicated to financing social and cultural projects. Compare that to the disaster that has befallen the Northern Rock Foundation. Patrick Collinson The Guardian, Saturday February 23 2008

What does seem certain in the UK is that the property market is going to be affected.

…possibly badly. House prices rose and rose over the past few years, contrary to many experts who, quite logically, kept predicting a price crash.

What it seems they missed was that the UK – unlike the USA – is overcrowded and has only a finite amount of land.

In addition the opening of the borders to the new wave of immigrants from places like Poland… meant a huge influx of cheap foreign labour came in.

Not only did these foreigners undercut our honest salt-of-the-earth British builders and plumbers who had gained such a wonderful reputation, what with their reliability, working long hours for honest wages, but they also needed somewhere to live.

This meant that all the speculative buy to let landlords had customers. So our nice new Polish plumbers not only did some work but they acted as a lubricant on the UK property market.

Unfortunately Stanislav and his mates look as if they are drifting back to Poland. (You’re welcome back any time pal). So that might put more pressure on the buy to let brigade might not be able to find new tenants, and might be forced to sell.

At the same time, thanks to the credit crunch, the Ones Who Should Be Looked Upon With Respect who run our Building Societies and Banks are putting their ankle length skirts back on and no longer dancing with any old stranger…

… meaning they are not lending to any comers any more, particularly not to anyone with bad credit – of which there are quite a few… thanks to the irresponsible lending of the same banks, who knew at the time that they should have known better but did it anyway.

A fairly certain outcome is that UK property prices will go down

.. possibly only by 5%, as predicted by the Nationwide recently, possibly by a whole lot more.. See Freeze on Lending to Hit House Prices – Sunday Times

The “perfect storm” for the housing market sees the following weather fronts colliding:

As people start coming to the end of their fixed term deals they are going to find it difficult to get the cheap mortgage deals they were expecting. Which means they will have less money to spend… which means there will be a recession, which means there will be less money around… which means people will have less money to spend…

Three million people will be coming off fixed rate deals in the next year or so.

It is estimated that they will have to find an extra £300 a month to meet the higher mortgage costs.

Some people will not be able to meet their higher payments which will lead to more repossessions.

Meanwhile people will be reluctant to sell if they aren’t getting a good price which will contribute to a major slowdown in the UK residential property market.

In any event, considering all the newly repossessed properties on the market… it will probably be a buyers market.

Two possible effects of the internet on house prices may be worth noting here.Firstly, the UK Land Registry records all property sales. property bought or sold since April 1, 2000 is available on their website. This is replicated by several property websites. So anyone buying a house that the vendors themselves bought after 2000 will be able to quickly see what it was worth then.While all prices are available in the archives, human nature, with its habit of taking the quicker easier road and making up its mind, prematurely and stubbornly, dictates this will result in those post 2000 houses being harder to sell for very much more than the vendors paid for them. Secondly more people will probably use the “for sale by owner” type websites. By paying a small fee to advertise online and saving 3% on Estate Agents fees, houses might sell for less but still net their owners as much as before

It Might Not be that Bad

Reasons to be cheerful:

• The regulators are much more organised that they used to be. In the Big Bad Banking Crisis of ye olde 1907 the great JP Morgan single handedly averted a similar crisis by knocking heads together. His initiative, unprecedented at the time, became the model for future regulation.

• Ben Bernanke is an expert on what happened with the Great Depression

• In the UK land will not grow on trees. There will still be a basic scarcity factor to make property valuable.

• The immigrants, be they rich or normal workers, will continue to come from Eastern Europe and elsewhere for many a year.

• As part of their contribution to our economy they will have to pay for somewhere to live. After a normal readjustment to the market, prices will probably remain basically sound.

• The noble trade of Mortgage lending will continue. It just won’t be as stupid as before. Well it’ll be a while at least before the madness of 125% loan to values in no-go areas returns. Till then it will simply go back to where it was in the 70s and 80s… responsible lending based on a look at the applicants reliability and ability to repay.

• The economy itself will be OK. “Fortunately, and contrary to some of the things you may have read and heard, [credit is not suddenly drying up]. Credit is certainly tougher to get hold of for some borrowers and will be for some time, but there is still plenty around. David Smith, Economics Editor of The Sunday Times.

It could get much worse

aaaiiieee. We’re all going to die There are some arguments that things could be much worse

• “The global economy is built on sand, or rather a vast edifice of credit. Credit gives investors the same kick as alcohol offers; it makes them feel invincible. As they borrow money to buy assets, their actions make asset prices rise. Rising prices make banks feel more confident about lending money, giving the spiral more impetus”. From the otherwise more optimistic Philip Coggan, Buttonwood columnist for The Economist

• Fred Harrison’s 1999 book, Boom Bust: House Prices, Banking and the Depression of 2010 identified a property cycle from over 300 years of history with the major conclusion that housing booms precede recessions. In 2005 Harrisson, the director of the Land Research Trust refined his date by saying the crash would “All happen in 2008”

• Harrison also says the difference this time is Globalisation / market liberalisation means that the enitire world economy is much more inter twined and co dependent that it has ever been before. So no one is truly in control.

• … and: “the best thing investors can do for themselves is to shift their portfolios into assets that can quickly be liquidated. Don’t believe anyone who says that the property market is going to recover strongly from here and don’t believe anyone who says that even if it doesn’t, the effect of housing on the wider economy is marginal. It isn’t. It is absolutely key to the health of both the UK and the global economy.

• “Or it could be that the seeds of the next downturn are already sown, and are reflected in the recent rise in bond yields in major economies to their highest level for several years. Bond yields are important because they reflect two related things – market expectations of inflation and market expectations of interest rates, over the longer term. So the recent rise tells us the markets have become gloomier about inflation, or about interest rates, or both. Personal website of David Smith, Economics Editor of The Sunday Times (Note this is same chap as in the optimists corner above)

• Alan Greenspans, the much lauded former chairman of the US Federal Reserve take on the problem is: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.” See Financial Times

• Anna Schwartz, the “revered” montarists says it’s all Greenspans fault: “while chair of the Fed the central bank itself became the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce”. Oh dear. When the blame game starts between elderly Americans there must be a problem. (Then again, these aren’t the nice cuddly America old folk we all love. These are high priests of the discredited monetarist theory) Anna Schwartz blames Fed for sub-prime crisis

• The word credit is from the Latin word credere (“to trust”). The problem now is the lack of faith has turned the subprime mortgage crisis into what is possibly the worst financial crisis for several decades To read more on the real pessimists view points a “good” place to start is the Prudent Bear website of David W. Tice But the final word from us is that any crash won’t last too long. Everyone over the age of 35 in the UK will remember the severe
housing slumps of the eighties and early nineties. The thing is that houses that could not be sold for a pittance then, subsequently sold for huge multiples of what they used to be worth. At the time people really though things would never pick up again. But boy did they. It is this recognition that one day property will be worth something again that will keep a “bottom to the market”. As to the wider economy; humans need to eat. They need to trade. As long as the sun shines and food can be grown there will always be farmers and traders. The real issue is whether the serious concerns about the environment come true. If food can’t be grown that is where we will have a real problem.