Global financial markets went pear-shaped last week. They do that from time to time. The details are always different but the underlying cause of the problems is always the same: a prolonged boom makes people greedy, those greedy people take too many risks, subsequently come unstuck, and take other people down with them.
Financial market crashes are all permutations of this same morality play.
The so called ‘sub-prime’ (understatement of the year) crisis has its roots in the housing boom which gripped the United States five years ago. In 2002 and 2003, there was a bonanza in residential property caused by record low interest rates and surging house prices. Everyone wanted to be in real estate, and everyone thought they could make a quick buck.
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It used to be relatively hard for people with low incomes or bad credit ratings to get a home mortgage. But as rates became very low, and house prices began to rise quickly, lenders (banks and mortgage companies) changed their attitude toward high-risk borrowers. Suddenly, it seemed like everyone could make money out of real estate. So, lenders started to give credit to (almost) anyone.
Loans to poor people are called ‘sub-prime’ loans they are risky because there is a higher chance that the loan won’t be repaid, but they are attractive to investors because the interest rates are higher.
Sub-prime lending is highly controversial. As a practice, sub-prime lending has the advantage of giving poorer people the chance to own a home. But critics have recently alleged that the companies pushing sub-prime loans were corrupt, that they encouraged people to inflate the size of their incomes on loan forms, and deliberately lent to people who were unlikely to meet their commitments.
For a while, everyone made a lot of money out of sub-prime loans. The poor people borrowing liked them because it enabled them to buy a house and watch the value of the house rise as the market took off. The lenders loved sub-prime loans because they could sell them to investors who liked the idea of high-return financial assets backed by seemingly secure ‘bricks and mortar’ real assets.
The problems started in 2006 when interest rates started to rise and property values started to fall. Some of the home owners found that they were unable to meet their repayments. As their chance of being repaid became remote, the value of the outstanding loans fell dramatically.
This reduction in value has a ricochet effect through the financial system because the original sub-prime companies have (in many cases) sold their loans to investors as mortgage-backed bonds that is, an investment company can pay the sub-prime company upfront for the right to receive the interest on its loans. To make things worse, the investment companies often borrowed to buy these rights. Now that their value has dropped, they also cannot repay their loans.
The immediate consequence of this was a blow to the sub-prime homeowners (who often suffered foreclosure) and to the lenders and investors (who lost some of their money as house prices fell).
The pressing question now is how will the effects of the crisis extend beyond the mortgage market in the US?
In Australia, the crisis has dragged share prices down about 10 per cent (as of 16 August) from their record highs last month. But the key thing to remember is that prices are still about 2 per cent higher than the market close last year. And this fall is relatively small compared to the huge growth in the market we’ve seen in the last 3 years.
Most of the Australian companies which have seen their share prices fall have nothing to do with the US sub-prime mortgage market they are just collateral damage in a nervous share market where many people already have their finger poised above the sell button.
The earnings of Australian businesses are generally strong, and as long as that continues it’s likely that, by itself, this crisis will pass over our heads and most people will remain relatively unaffected.
The concern for all of us is that the crisis will not pass, but rather that it will lead to a recession in the US which drags on the global economy. The real test then, is the reaction of US consumers. They have shopped the world out of trouble on more than one occasion in recent years, not least in the recession that followed 9/11 when President George W Bush asked Americans to spend their way out of economic decline. Consumerism was cast as the new patriotism. And it worked.
The problem now is that much of the bullish spending of the US consumer was financed by buoyant property prices. During the housing bubble, homeowners had been using their growing property wealth to increase their consumption through refinancing or second mortgages. As house prices are now flat or declining, and the level of personal debt is higher and more expensive, consumers have more and more reasons to stay away from the shops.
The US generates about a quarter of global GDP, and if it stops spending this will have a significant impact on global markets especially the emerging export economies of China and India. And this would consequently impact on the economies (like Australia) which supply the raw materials fuelling Chinese and Indian growth. However, even if the US goes into recession, there is now strong growth in Europe and Asia to take up some of the slack.
So, there’s still a good chance that the sub-prime crisis will have very little effect on most Australians. Still, it’s a cautionary tale worth heeding lest we allow bigger greed to lead us into a more severe crisis in the future.