The US sub-prime mortgage crisis explained

‘Sub-prime’ lending was lending money to people who were high risk. Mostly, it was mortgage lending, but there were also loans for large household items and cars.

Why would banks and finance companies lend to high-risk clients?

Simply put, it was a case of supply exceeding demand.

The increase in the supply of money was due to the wealth generated by several things: the technology boom, government spending on the Iraq War, and the growth of the EU to name a few.

But mostly it was due to the economic rise of developing countries like China, India, Russia and Brazil.

The Chinese, in particular, have a tendency to save their money rather than spend it on consumer items.

Chinese banks then lent the money to overseas banks. In effect, Chinese savings fuelled a consumer and property boom in the United States and further afield.

More money being deposited in US banks meant more had to be lent out to make a profit. Pressure is put on sales people to do this and naturally lending standards slip.

In addition to this, the Clinton administration encouraged banks to lend to poorer people to help them into their first homes.

Why were US consumers so keen on property?

Money was cheap. Like any good or service, the price of money goes up and down depending on how much there is compared with how much money people want. This price is the interest rate you pay at the bank.

As mentioned, there was a lot of money in supply which drove the price down.

The US Federal Reserve had also tamed the inflation problems that had prevailed since the ‘60s and could afford to drop their interest rate and encourage more spending

When the ‘dotcom bubble’ burst in 2000, central banks cut interest rates further to avoid an expected recession.

Investors looked for safer investments than the share market and turned to property.

Two things followed in 2001that further fuelled the property boom – the September 11 terrorist attacks, which led to further interest rate cuts to avoid a fall in confidence; and President George Bush’s promised tax cuts.

The amount required for a deposit was also less because banks were willing to lend so much.

All in all, money was available and cheap, and property was safe. Or so they thought.

Selling the bad loans on to investors

Banks or mortgage agents did not keep the risky loans themselves, or ‘on book’. Instead, they sold them on to other, mostly larger, banks to invest in or on-sell.

This is ‘securitisation’ and it works like this: an investor, the larger bank or a pension fund, puts their money into an investment backed by assets – in this case, houses.

The interest paid on the home loans is the income for the investor.

These investments, or ‘securities’, are called the now infamous ‘CDOs’ or collateralised debt obligations.

These investments were assigned different levels of risk depending on the standard of the borrowers. The investor was paid a return reflecting the risk – at the risky end, often around 12%.

The problem with these was that the actual risk was often much higher than the stated risk – which is why credit ratings agencies have come under so much heat since the crisis.

Industry experts claim they were paid to make the security ‘appear’ less risky. This is so it could meet the investment criteria of the various funds.

Oops – the flawed assumption

The crucial assumption made was that the assets backing such investments – e.g. houses – would not only maintain, but increase their value – the idea that property always goes up.

Which is why, at the front end of the chain, banks were willing to lend money to an otherwise dubious group of customers known as ‘NINJAs’ – no income, no job or assets.

The assumption was that if the person borrowing the money walked away from their house, the bank would still have an asset worth more than what it was when they lent the money out.

Then, the housing boom turned into a bubble, the bubble burst and the asset values collapsed.

The end of the party

So the property was worth less than the amount the bank loaned on it. The investor found they were not getting a 12% return on a risky asset, and not only that, but also they couldn’t get their money back due to the drop in property values.

AIG insured many of these investments using ‘swaps’, providing investors with a back-up. However, greed caused them to ‘over-insure’, meaning they didn’t have enough money to pay all the claims.

Which is why, in turn, the US government found itself bailing out banks and AIG. And also why there is now a worldwide discussion about requiring banks to hold a higher level of funding against the money they lend out.

Future proofing

Here on the first anniversary of the collapse of Lehman Brothers, that debate is still happening – it was the main topic of a meeting of international central bankers in Jackson Hole, Wyoming, three weeks ago.

The favoured approach appears to be ‘dynamic provisioning’ – a system requiring banks to hold increasing levels of money against their lending as an economic cycle is on the up.

Less money in supply would mean higher average interest rates, which banks will also need to attract funds.

It will also, of course, mean banks will lend out less money – and will be more careful about who they lend it to.

By Rob Hosking