HAL 9000
02-24-2009, 10:39 AM
I have been asked (elsewhere) to give an overview of the credit crunch that a layperson could understand. I thought I would post it here because people might find it helpful, or might be able to correct any obvious errors.
1. The Traditional Banking Model.
The traditional banking model sees banks taking short term deposits from retail customers and lending that money on a long term basis – typically in the form of a mortgage. Additional capital for lending can be accessed from wholesale money markets. The bank lends this money to homeowners and gambles that the interest collected will balance the risk of repayment default and turn a tidy profit.
A slight problem occurs when it comes to reserving for risk. In order to borrow from wholesale markets, Wholesale Lenders require that a mortgage lender (bank) holds additional capital against the risk that unexpectedly high numbers of homeowners default; this is known as risk capital (Banks are also legally bound by regulators to hold a certain minimum level of risk capital).
Typically, a wholesale lender would not lend money to a bank (to pass on as a mortgage) unless it can see significant reserves and risk capital in place to gain satisfaction that it will get its money back. The higher the level of capital held in comparison to the liabilities and risk capital requirements of the bank, the safer that bank is and the better its credit rating (and the better the terms on which it can borrow money).
2. Securitising the Mortgage Book
The above is a simplified model but it effectively how banks operated for much of the 20th century. It is complicated by the realisation of banks that they can securitize their mortgage book. This means that instead of banks paying out a lump sum (mortgage) and getting regular repayments in return, the bank can essentially sell the right to receive those repayments to someone else for a lump sum now. So, for example, a bank can lend $100,000 to a homeowner in exchange for repayments worth $250,000 (net present value) over 20 years – they can then sell that income stream to a third party (for say $150,000) right now. In practice, they pool lots of mortgages and sell lots of securities backed by the pool.
For the bank this is great because, it passes the credit risk (that the homeowner will default) on to a third party and gives them cash right now, that they can put to work by lending it to more homeowners. This is an Asset (or mortgage) Backed Security. It is like a bond; the third party pays money to the bank and receives in exchange a regular income stream from a book of mortgages. In the event that defaults are high in the mortgage book and the coupon payments cannot be met, the proceeds from the liquidation of homes go to support the bond. So it is the third party (buyer of the ABS) who bares the risk of defaults in the housing market.
The banks now look safer because they have de-risked their balance sheets and passed that risk on to third party investors. This means that banks have lower risk capital requirements, higher capital surpluses, better ratings and better access to cheap borrowing on wholesale markets.
So far so good, but here is the problem. The banks are getting flooded with capital (partly because of the securitisation model and partly because of government and social pressures to increase homeownership) and so they look to lend that capital to (very willing) homeowners (and also other forms of lending – business loans, credit cards etc). Basic economics here, the supply of houses is basically fixed but the availability of finance is high – this pushes up house prices. Banks are competing with each other to win a limited volume of business in the market, so they compete with each other by offering cheaper rates, dropping lending standards and generally trying to lend money to anyone with a pulse. House prices go up further, and banks think that as long as that continues, they can drop lending requirements further – who cares about defaults when house prices are rising. The underlying asset easily covers the loan – right?
Another problem. In the US, people by houses through mortgage brokers. Brokers arrange mortgages and gather details about the customers ability to pay and pass it on to the bank. In the past (simple model above) the bank has an incentive to check that this data collection is accurate (because they bare the risk if it isn’t), but in the securitised mortgage model, they don’t care because the risk is getting passed on to the third party investors (ABS buyers) anyway. Sure investors buying mortgage backed securities care about the quality of the underlying mortgage book, but that information is being passed to them through two institutions (broker and bank) who both have an incentive to massage figures and conduct poor due diligence. The quality of this data started to suffer as lending standards dropped.
3. The trigger
Suddenly, in 2007, mortgage defaults spiked in the US. The instant effect was the realisation that the Asset Backed Securities were far riskier than previously thought (investors suddenly realised the data on the mortgage books was misleading). Over night, ABS’s got downrated and everyone decided to sell them. Except they couldn’t because the market had disappeared, no buyers. The value of an ABS crashed and this had a number of effects:
Companies, like banks actually held some of their spare capital reserves in ABS’s and so their reserves were immediately written down. At the same time they stopped being able to securitize their mortgage risk which had to remain on balance sheet – thus increasing their required risk capital. So you have capital available going down and capital required going up at the same time.
This meant that such entities are immediately less favourable to lend to (remember rating strength is based on excess capital available over risk capital required) and in many cases, technically insolvent. The wholesale markets ‘dried up’. Which means that those companies with cash to lend, did not want to lend it to the banks anymore because they no longer look solvent.
So banks had a liquidity crises, they could not access cash with which to write new mortgages, which means no-one could buy houses, which means house prices crash. This leads to further weakening of asset backed securities (because they are secured on the houses) and the cycle repeats.
In the UK, the Building Society Northern Rock found it could not access cash from either selling ABS’s or from wholesale markets (they got hit first because they relied heavily on borrowing from wholesale markets). Not only could they not write mortgages, they could not even pay out on deposit accounts. This lead to a run on the bank and the Bank of England had to step in with an emergency liquidity injection so depositors could get money out.
Also worth noting that banks have huge number of employees now twiddling their thumbs, not writing business = big financial loss.
Meanwhile, investment banks and large insurers held huge numbers of ABS’s and had also written Credit default Swaps (CDS - insurance against defaulting bonds) so were massively on the hook for the collapsing ABS market. AIG for example wrote a lot of CDS’s which is why they went wrong. A complicated mixture of Asset Backed Securities and Credit Default Swaps made it difficult to tell how an institution would be impacted if the housing market collapsed.
Most of the finance industry had to write off huge chunks of capital (about $3 trillion) leaving them very weak and unattractive to lenders.
4. Government response.
So far much of the response has been about bail out. It is about improving the solvency position (creating capital surplus over risk capital requirement) so that those in a position to lend to banks are confident that they can do so.
The reasoning is that it is investment and lending which fuels economic growth. Without the banking sector there can be no investment in new ideas or efficiency savings and it is these things that make us a little richer each year. The collapse of the banking sector means the collapse of all other sectors that need to speculate to accumulate.
So far this has not worked, lending is still frozen and it is now having its inevitable knock on effect on the wider economy i.e. job losses, loan defaults, repossessions, bankruptcies etc. The latest move by governments seems to be to try and stimulate economic artificially by borrowing money and creating jobs. The economic equivalent of defibrillation which is a Keynesian approach to economics. This does not solve the underlying problem, but can reduce the harm until the banking sector starts working again.
5. Who is to blame (in my opinion)?
Lots of individuals have screwed up. People have borrowed more than they can afford, shareholders have demanded ambitious returns, banking execs have achieved those returns by taking unreasonable risks. Lots of individuals are to blame.
However, human nature is what it is. People generally can be relied upon to maximise their personal utility (or that of their immediate family). Fundamentally, this is a system failure, the failure to appropriately incentive rational people to behave in a way which delivers the maximum good to society as a whole. People are idiots and they are selfish, always have been, always will be. The trick is design a system that dangles the right carrots at the right time to encourage behaviour that benefits all society. We are guilty of not having enough carrots.
Unregulated markets do not deliver optimal solutions, they deliver failure. The current crisis is the natural market response to a deregulated lending market with information asymmetry.
There was a fundamental logical fallacy amongst lawmakers and regulators in assuming that we had somehow mastered economics when all that was happening is that the technological revolution had driven us into an extended period of growth (in my opinion).
In future, much more regulation around lending, investment and risk management will be required in order to ensure a risk bubble is not able to form again.
1. The Traditional Banking Model.
The traditional banking model sees banks taking short term deposits from retail customers and lending that money on a long term basis – typically in the form of a mortgage. Additional capital for lending can be accessed from wholesale money markets. The bank lends this money to homeowners and gambles that the interest collected will balance the risk of repayment default and turn a tidy profit.
A slight problem occurs when it comes to reserving for risk. In order to borrow from wholesale markets, Wholesale Lenders require that a mortgage lender (bank) holds additional capital against the risk that unexpectedly high numbers of homeowners default; this is known as risk capital (Banks are also legally bound by regulators to hold a certain minimum level of risk capital).
Typically, a wholesale lender would not lend money to a bank (to pass on as a mortgage) unless it can see significant reserves and risk capital in place to gain satisfaction that it will get its money back. The higher the level of capital held in comparison to the liabilities and risk capital requirements of the bank, the safer that bank is and the better its credit rating (and the better the terms on which it can borrow money).
2. Securitising the Mortgage Book
The above is a simplified model but it effectively how banks operated for much of the 20th century. It is complicated by the realisation of banks that they can securitize their mortgage book. This means that instead of banks paying out a lump sum (mortgage) and getting regular repayments in return, the bank can essentially sell the right to receive those repayments to someone else for a lump sum now. So, for example, a bank can lend $100,000 to a homeowner in exchange for repayments worth $250,000 (net present value) over 20 years – they can then sell that income stream to a third party (for say $150,000) right now. In practice, they pool lots of mortgages and sell lots of securities backed by the pool.
For the bank this is great because, it passes the credit risk (that the homeowner will default) on to a third party and gives them cash right now, that they can put to work by lending it to more homeowners. This is an Asset (or mortgage) Backed Security. It is like a bond; the third party pays money to the bank and receives in exchange a regular income stream from a book of mortgages. In the event that defaults are high in the mortgage book and the coupon payments cannot be met, the proceeds from the liquidation of homes go to support the bond. So it is the third party (buyer of the ABS) who bares the risk of defaults in the housing market.
The banks now look safer because they have de-risked their balance sheets and passed that risk on to third party investors. This means that banks have lower risk capital requirements, higher capital surpluses, better ratings and better access to cheap borrowing on wholesale markets.
So far so good, but here is the problem. The banks are getting flooded with capital (partly because of the securitisation model and partly because of government and social pressures to increase homeownership) and so they look to lend that capital to (very willing) homeowners (and also other forms of lending – business loans, credit cards etc). Basic economics here, the supply of houses is basically fixed but the availability of finance is high – this pushes up house prices. Banks are competing with each other to win a limited volume of business in the market, so they compete with each other by offering cheaper rates, dropping lending standards and generally trying to lend money to anyone with a pulse. House prices go up further, and banks think that as long as that continues, they can drop lending requirements further – who cares about defaults when house prices are rising. The underlying asset easily covers the loan – right?
Another problem. In the US, people by houses through mortgage brokers. Brokers arrange mortgages and gather details about the customers ability to pay and pass it on to the bank. In the past (simple model above) the bank has an incentive to check that this data collection is accurate (because they bare the risk if it isn’t), but in the securitised mortgage model, they don’t care because the risk is getting passed on to the third party investors (ABS buyers) anyway. Sure investors buying mortgage backed securities care about the quality of the underlying mortgage book, but that information is being passed to them through two institutions (broker and bank) who both have an incentive to massage figures and conduct poor due diligence. The quality of this data started to suffer as lending standards dropped.
3. The trigger
Suddenly, in 2007, mortgage defaults spiked in the US. The instant effect was the realisation that the Asset Backed Securities were far riskier than previously thought (investors suddenly realised the data on the mortgage books was misleading). Over night, ABS’s got downrated and everyone decided to sell them. Except they couldn’t because the market had disappeared, no buyers. The value of an ABS crashed and this had a number of effects:
Companies, like banks actually held some of their spare capital reserves in ABS’s and so their reserves were immediately written down. At the same time they stopped being able to securitize their mortgage risk which had to remain on balance sheet – thus increasing their required risk capital. So you have capital available going down and capital required going up at the same time.
This meant that such entities are immediately less favourable to lend to (remember rating strength is based on excess capital available over risk capital required) and in many cases, technically insolvent. The wholesale markets ‘dried up’. Which means that those companies with cash to lend, did not want to lend it to the banks anymore because they no longer look solvent.
So banks had a liquidity crises, they could not access cash with which to write new mortgages, which means no-one could buy houses, which means house prices crash. This leads to further weakening of asset backed securities (because they are secured on the houses) and the cycle repeats.
In the UK, the Building Society Northern Rock found it could not access cash from either selling ABS’s or from wholesale markets (they got hit first because they relied heavily on borrowing from wholesale markets). Not only could they not write mortgages, they could not even pay out on deposit accounts. This lead to a run on the bank and the Bank of England had to step in with an emergency liquidity injection so depositors could get money out.
Also worth noting that banks have huge number of employees now twiddling their thumbs, not writing business = big financial loss.
Meanwhile, investment banks and large insurers held huge numbers of ABS’s and had also written Credit default Swaps (CDS - insurance against defaulting bonds) so were massively on the hook for the collapsing ABS market. AIG for example wrote a lot of CDS’s which is why they went wrong. A complicated mixture of Asset Backed Securities and Credit Default Swaps made it difficult to tell how an institution would be impacted if the housing market collapsed.
Most of the finance industry had to write off huge chunks of capital (about $3 trillion) leaving them very weak and unattractive to lenders.
4. Government response.
So far much of the response has been about bail out. It is about improving the solvency position (creating capital surplus over risk capital requirement) so that those in a position to lend to banks are confident that they can do so.
The reasoning is that it is investment and lending which fuels economic growth. Without the banking sector there can be no investment in new ideas or efficiency savings and it is these things that make us a little richer each year. The collapse of the banking sector means the collapse of all other sectors that need to speculate to accumulate.
So far this has not worked, lending is still frozen and it is now having its inevitable knock on effect on the wider economy i.e. job losses, loan defaults, repossessions, bankruptcies etc. The latest move by governments seems to be to try and stimulate economic artificially by borrowing money and creating jobs. The economic equivalent of defibrillation which is a Keynesian approach to economics. This does not solve the underlying problem, but can reduce the harm until the banking sector starts working again.
5. Who is to blame (in my opinion)?
Lots of individuals have screwed up. People have borrowed more than they can afford, shareholders have demanded ambitious returns, banking execs have achieved those returns by taking unreasonable risks. Lots of individuals are to blame.
However, human nature is what it is. People generally can be relied upon to maximise their personal utility (or that of their immediate family). Fundamentally, this is a system failure, the failure to appropriately incentive rational people to behave in a way which delivers the maximum good to society as a whole. People are idiots and they are selfish, always have been, always will be. The trick is design a system that dangles the right carrots at the right time to encourage behaviour that benefits all society. We are guilty of not having enough carrots.
Unregulated markets do not deliver optimal solutions, they deliver failure. The current crisis is the natural market response to a deregulated lending market with information asymmetry.
There was a fundamental logical fallacy amongst lawmakers and regulators in assuming that we had somehow mastered economics when all that was happening is that the technological revolution had driven us into an extended period of growth (in my opinion).
In future, much more regulation around lending, investment and risk management will be required in order to ensure a risk bubble is not able to form again.