How bad will the credit crunch get?

One of the striking figures to emerge from the fire sale of Bear Sterns, formerly the fifth largest US investment bank, is the huge gap between its assets and debts. It had $11.8 billion in capital, which might sound a lot … until you add up its debts, which came to $395 billion.

The underlying problem is that, in the search for profits, Bear Sterns kept on lending out far more money than it actually had, making up the difference by borrowing money from other firms, who were willing to lend money to Bear Sterns on the basis that it did have just enough assets to keep the show on the road and was bringing in enough money to be able to keep up payments on their loans.

In the good times, this can bring huge profits and fast growth, but if the good times come to an end, the gap brings the whole edifice crashing down. In the case of Bear Sterns, the people it had borrowed money from wanted some of it back, but the firm couldn’t get money back in turn from the people they had lent it on to and the whole thing came crashing down with Bear Sterns being sold off for a mere 3% of what it was valued at the previous week.

But why couldn’t Bear Sterns just get the money back from the people it had lent it on to? There’s a whole host of financial complexity involved in answering the question, but much of it comes down to this: the US financial system has loaned huge amounts of money to Americans to buy property but people who have taken out these mortgages are now often unable to afford them because (1) property prices have started falling sharply, an (2) it has turned out that a lot of dodgy loans involving sharp practice were made where people were conned into taking out mortgages which they actually could not afford because of hidden charges and penalties.

Making the whole situation more precarious is the leverage effect: if I have £10 in assets and on the basis of that make £100 in loans, then a £5 fall in my assets would mean I have to cut back the loans I’ve made to £50. A small fall in asset values produces a much bigger financial headache.

The current US situation poses more dangers than the British house price falls in the 1990s poised to our financial system because the leverage levels (£100 loans based on only £10 assets in my example) are much higher than they were then in the UK.

And that is why this graph of US property prices is so particularly worrying:

US house prices

Not only has there been a sharp decline, breaking a long term trend, but because of the leverage effect the decline in property prices has a much greater knock-on effect on other institutions.

The latest estimates are that the overall gap between the value of US property and the debt that it is mean to underwrite is between $2 trillion and $3 trillion now. That’s not a problem likely to go away quickly.

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11 Comments

  • Although US house prices, from your graph, are still double what they were in 2000.

  • Peter Bancroft 22nd Mar '08 - 10:06am

    Mark, I’m not sure that you’ve correctly understood the issue at hand. There’s nothing intrinsically unsound about purchasing credit to serve customers – the problems in the US relate firstly to black-boxed debt where the risk was unclear and secondly to the too easy access to credit (even though relatively easy access to credit is a key tool of social mobility).

    Leaving aside the expected ignorant attacks on financial markets – on the point of “who cares” I guess it all depends on what you care about.

    Climate change is a real threat to life, but today’s economy is social mobility write large – it’s our access to choice and it relates to an individual’s access to self-improvement and sustainable living.

    If we say “who cares” about all that, then there’s really no point in caring about anything.

  • Banks have assets as well as capital. The capital is only needed when the assets go bad. In Bear Stearns case they did, and so the shareholders lost out. But BS is an exception, even in the US. Risk and reward go together, and one of the points of shareholders is to face the risk of being wiped out. I hope that those who value Northern Rock note the 98% fall in the share price of BS, and apply something similar to NR’s shareholders claims for compensation.

    But the effects on Joe Public are limited until we get into a widespread negative equity situation. Even in the US negative equity is still relatively uncommon.

    When house prices have risen very sharply, a decline leaves very few people with negative equity. On the above graph it would take a 30%+ fall in house prices for someone who took out a 100% interest only mortage in 2003 to be in negative equity. In general only the most recent first-time buyers are vulnerable to negative equity.

  • It’s gonna get worse before it gets better if news that total accumulated household debt (at £1.4tr) continued growing at above-inflation rates, even after the run on Northern Rock.

    Considering that this total has now (as of results published this week) surpassed 50% of the total equity held in property (£2.8tr) and you start to see the problem (let’s not get into arguments of differential exercises about who suffers more, as I think that is obvious – those who can least afford to).

    Even by Brown’s own golden economic rules we are starting to touch upon dangerous territory, so reports that consecutive interest rate cuts are likely are not surprising, if frightening.

  • Think of the kids... 7th Apr '08 - 10:55am

    Mark, but isn’t the real lesson of this exercise that the environment cannot handle people spending dosh they haven’t really got on cars/holidays that screw the planet – and that the ‘credit crunch’ may be a very good thing if it teaches people to ‘live within the means’ of the planet ??

    Although the flip side is that with the oil price shooting through the roof, other oil sources [such as tar sands] are exploited to keep the supply high, and doing zilch to really cut demand.

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