I’m out of the office this week.
So given that it’s currently around about the tenth anniversary of the great financial crisis kicking off (depending on exactly when you date it from), I thought I’d reprint an old piece from the archives.
Below is a cover story I wrote for MoneyWeek magazine back at the end of July 2007. It’s all about the credit crunch and its implications (you can read the original article here).
For context, by this point, US subprime mortgages were clearly an issue. In April, New Century Financial, a big US mortgage lender, had filed for bankruptcy protection. Then, during July, a couple of Bear Stearns hedge funds had blown up.
However, Northern Rock was still a functioning bank, albeit not for long. Bear Stearns was still afloat. Lehman Brothers was just another American investment bank. And as recently as May that year, US Federal Reserve chairman Ben Bernanke had said that “we see no serious broader spillover to banks… from the problems in the subprime market”.
It doesn’t get everything right, but I think the piece gives a flavour of the atmosphere of the time.
I also think it’s a valuable reminder that this didn’t just blow up out of nowhere. People still have a tendency to view the financial crisis as a “black swan” – an entirely unpredictable (and somewhat malign) act of God.
Of course, the precise form that the crisis took was unpredictable, and a lot worse than even the most bearish observers expected. But if nothing else, I think this piece makes it pretty clear that it was anything but a bolt from the blue.
Is the tidal wave of cheap money about to break?
MoneyWeek issue 345, 27 July 2007
Any investor who can read a newspaper will by now have heard of CDOs [collateralised debt obligations] and subprime mortgages. Some might even have a rough idea of what they are. But for anyone who’s still confused by the murky world of credit derivatives, and how they are linked to mortgages and the broader economy, we can sum them up in one simple phrase: they’re the canaries in the coal mine. And their plunging values are warning us that the cheap money boom is giving way to a credit crunch.
Asset prices across the world and all markets have been lifted on a wave of money, unleashed largely in the wake of the tech-stock crash and the September 11th terrorist attacks. Alan Greenspan, then Federal Reserve chairman, cut US interest rates sharply and kept them there, making it extremely cheap to borrow money, and lulling the entire world into a false sense of security.
Meanwhile, cheap goods and labour from Asia – and China and India in particular – helped to keep a lid on inflation figures, which enabled central banks to justify keeping interest rates low, even as oil prices soared and property prices took off. This apparently stable, brave new globalised world of low interest rates and low inflation meant investors felt happy to borrow more and more money to take on ever more risk.
Arguably, one of the riskiest places to which all this money flowed was the US housing market. Some bright spark figured out that you could lend money to people with poor credit records and charge them higher interest rates. As long as house prices kept rising, the chances of them defaulting were relatively low – they could always remortgage.
Another bright spark realised that you could then parcel all these mortgages up into bonds and sell them to yield-hungry investors. If you were careful about how you sliced it, the top bits of these bonds could even get the top credit rating, because although they were the same subprime rubbish that was in the bottom sections, the lower tranches would take the hit first if anyone defaulted.
When they were offered investment grade bonds paying the higher yields you’d expect from sub-investment grade debt, investors from hedge funds to pension funds piled in, not quite believing their luck. As demand rose, more subprime lenders sprung up, competing with each other for business, until it reached a point where they were lending money to almost anyone with a pulse.
As lending standards were tumbling, interest rates were creeping higher, and builders kept building more houses. As supply outstripped demand, house prices began to fall. Suddenly, when payments rose from the initial low “teaser” rates, all those subprime borrowers could no longer remortgage against the rising value of their homes. And so more people than expected started to default on their mortgages.
That meant that those mortgage-backed bonds, and all the derivatives spawned from them, weren’t worth as much as everyone had thought. Investment bank Bear Stearns produced the first casualties. Two of its hedge funds that had specialised in mortgage-backed debt have blown up and revealed that they had practically no value left in them.
Since then, credit-ratings agencies have downgraded several such bonds and it seems likely that things will only get worse. Another $500bn of risky home loans sold with low “teaser” rates are set to jump to much higher levels in the coming months as adjustable-rate loans taken out in 2005 and 2006 are reset. “It’s like an onion; as you peel back another layer it just smells worse”, said William Strazzullo at Bellcurve Trading to the FT.
Christopher Flanagan at JP Morgan Stanley reckons almost half of these borrowers will be unable to arrange new loans to cut their payments as lenders have belatedly tightened up on their credit criteria. Even Federal Reserve chief Ben Bernanke is now admitting that the losses could be in the region of $100bn.
Now, in the context of global financial markets, that’s big, but it’s not world-shattering. Unfortunately, the problems aren’t restricted to subprime.
The credit crunch spreads
As Bernanke also admitted, there are “increased concerns among investors about credit risk on other types of financial instrument”. When investors saw how rapidly subprime had collapsed, they started to ask themselves which other asset classes they’d been careless with. And they realised that they’d been careless with just about everything.
Now credit spreads on high-yield corporate debt have widened sharply, rising from 6.9% to 8.2% in just one month. In other words, investors are now expecting a much higher return for investing in risky assets – and that makes it more expensive for firms to raise money, or to fund buy-outs.
This could be a problem for investment banks. The most high-profile potential casualty of the squeeze is private-equity group KKR’s takeover of Alliance Boots. The banking consortium behind the deal has yet to find buyers for the £9bn of debt needed.
But that’s just the tip of the iceberg. Banks are already sitting on $100bn of debt from previous buy-outs that they haven’t yet been able to sell onto the markets. And a further $270bn will hit the market later this year, according to Ambrose Evans-Pritchard in The Daily Telegraph. If the banks cannot offload this debt, it could leave them with “far more risk on their books than they bargained for, and could ultimately force them to pull back sharply on lending”.
Already, 21 firms in the US have had to cancel bond sales “because nobody wants to buy them”, says Bloomberg. Combine this with forced selling of assets backed by subprime mortgages, and you have a real problem brewing.
TJ Marta, a strategist at RBC Capital Markets, says that some leveraged hedge funds could lose all their money, just like the two run by Bear Stearns, and if credit downgrades force mainstream investors to sell out of mortgage-backed assets at a loss, then “a vicious downward spiral could result, leading to the liquidation of other assets and positions, including the forex carry trade”.
This could have a nasty impact on assets with no apparent connection to US housing. As Bill Gross at Pimco puts it, “What has the Brazilian real to do with US subprimes? Nothing, except many of the same bets are held in hedge funds that by prudence or necessity will reduce their risk budgets to stay afloat.”
The knock-on effect could see asset markets across the world devaluing. But if it looks like markets are running into trouble, what’s to prevent central banks from just cutting interest rates and re-inflating the bubbles?
Inflation is rising
The reason central banks won’t cut interest rates immediately is that inflation won’t let them. One of the main things that has kept inflation down in recent years is that China has been exporting deflation – goods keep getting cheaper, while labour costs have been kept down by the influx of new workers into the global economy.
But now China has begun exporting inflation. Prices of US imports from China rose by 0.3% last month, “the first sign I’ve seen that this disinflation pressure from China’s cheap goods may be fading”, said Greenspan. China’s vast appetite for raw materials has continued to push the price of oil, metals and food higher, which in turn raises costs for consumers and firms, putting upwards pressure on wages and shop prices.
Even if central banks do cut rates – and with the dollar in its weak state, that would be a risky step for the Federal Reserve – the experience of Japan in the 1990s shows that slashing interest rates once consumer and corporate sentiment has turned from greed to fear is ineffectual.
As Merrill Lynch puts it, “it seems the era of cheap money is over”.