This week the AMP’s Dr Shane Oliver looks at the dominant event of the past year, i.e. the global financial crisis.
Specifically: What drove it and why was it so severe? Was it forecast able? What will it mean going forward beyond the current mess? And what are the lessons for investors? He writes:
The past 60 years has not seen anything like the freezing up of lending between global banks, the disruption to credit flows or the need for so many financial institutions in the US and Europe to be rescued as we have seen in 2008.
The current crisis is not the worst in Asia (1997/98 was) or Australia (the early 1990s was).
But for the world as a whole it is the worst financial crisis in the post war period.
So how did it come to this? What will it mean going forward? What are the lessons for investors?
How did it come to this?
While many are looking for easy scapegoats to blame, the origins of the current malaise are multifaceted and include:
Financial deregulation. Over the last 20 years this helped unleash much greater competition in the global financial system and hence the greater availability of debt.
It ultimately led to a failure of US regulators to keep up with new financial products and growth in leverage. This is not to say deregulation was wrong, but in some countries, such as the US, it went too far.
The shift from high inflation to low inflation. This saw interest rates fall, which was great, but it had the effect of encouraging borrowers to borrow more and drove investors to search for higher yields.
This led them to greater allocations to investments such as listed property trusts and of course the complex securities at the heart of the current problem. This occurred without due regard for the extra risks involved.
Financial innovation. Amongst other things this saw a massive expansion of the securitization approach to debt financing. This is where a financial organization (say a mortgage lender) “originates” a loan to a borrower (say a home owner).
These loans are then sold to other organizations that package them up with lots of other loans into securities which are “distributed” to investors all around the world. The theory was that by combining lots of loans the risk would be low.
Ratings agencies provided high credit ratings (e.g. AAA) for securities whose underlying loans would normally be regarded as sub-investment grade. A problem with the “originate and distribute” model is that there was no “bank manager” looking after depositors funds.
The US housing boom. These developments, spurred by low interest rates early this decade, came together to drive the US housing boom which was increasingly underpinned by a deterioration in lending standards. This saw a huge growth in loans to so-called sub-prime (or high risk) home borrowers in the US up until 2007.
The music stopped in 2006 when poor affordability and an oversupply of homes saw US house prices peak and then start to slide.
This made it harder for sub-prime borrowers to refinance their loans in order to maintain their initial low “teaser” mortgage rates.
As a result more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans to start suffering losses in 2007 – and this became the sub-prime mortgage crisis.
Rising unemployment and falling house prices have since seen the problem spread to all US mortgages.
But why did the sub-prime crisis drag down the whole world?
Firstly, the extent of bad loans and hence losses has been far worse than thought.
Secondly, record levels of debt in investment banks and hedge funds have accelerated the losses and the declines in key assets as positions had to be unwound to cut debt or meet redemptions.
High household debt has also made the economic fallout far greater and this has seen the crisis spread to countries such as China.
Thirdly, the distribution of securities investing in US sub-prime debt all around the world has led to a wider range of exposed investors and hence greater worries about which financial institutions are at risk.
Fourthly, just as greed played a role on the way up, fear played a huge role on the way down.
This is evident in the freezing up of lending between banks in the aftermath of Lehman Brothers failure on fears all banks are at risk or the dislocation in credit flows to good companies.
These factors all came together to result in a downwards spiral of falling share markets, falling confidence, reduced lending, reduced economic activity, more losses, then more falls in share markets, etc.
And this was all transmitted globally via trade flows, confidence effects and capital movements.
So fault lies with a range of players: the US home borrowers who weren’t aware of what they were getting into, the lenders who relaxed their lending standards, the ratings agencies, investors chasing returns without regard to risk, US regulators, and financial organisations for taking on too much risk.
And, as always, greed and fear also played a big role in magnifying the boom and then the bust.
The end result was a year of extremes
The end result has been a year of extremes, including:
- One in 10 US households with a mortgage now behind in their payments or in foreclosure.
- The de facto demise of the big five US investment banks, via bankruptcy, merger or conversion to banks.
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