How did $600-800 billion of US mortgage defaults cause a worldwide economic crisis? | Notes from Jim Haughey

Construction Market analytics and forecasting community header

home

communities

market insights

notes from jim haughey

blog post

Notes from Jim Haughey
Insight and Analysis of Construction Industry Trends	Get RSS Feed

Market Insights Home

How did $600-800 billion of US mortgage defaults cause a worldwide economic crisis?

Jim Haughey

RCD Chief Economist

Oct 13, 2008

$600-800 billion is a lot of money but not so much that it could not be absorbed by mortgage lenders, however painfully, without creating the worldwide credit freeze that is now abruptly slowing economic growth in every country and will push virtually all of the industrial countries into recession. When the financial problem was described as subprime mortgage defaults from August 2007 to August 2008, it was contained by the Federal Reserve Board. It took emergency measures and most of the FRB’s resources. But no commercial banks failed. The economy was wounded but recession was avoided. Then two months ago the problem moved to non-bank financial firms. They could not cope with it because they had fundamentally flawed risk management practices.

Commercial banks began writing down the value of their mortgage and mortgage bond assets beginning in 2006 and then made huge write-downs over the past year. These charges were largely in advance of actual losses. The losses were estimated and recognized before most of the mortgage defaults and foreclosures actually occurred. The abrupt rise in actual defaults and foreclosures early in 2008 forced non-bank financial firms to begin writing down their mortgage bonds that were now clearly worth less than face value when the anticipated foreclosures began to occur. The initial write downs caused losses and hence reduced capital but did not cause insolvency, except for investment banker Bear Stearns.

When a large number of mortgages had actually foreclosed or were in default, the holders of mortgage backed bonds demanded to be compensated for their losses. Many had bought guarantees that the bond principal and interest would be paid in full. These guarantees are termed credit default swaps and were sold largely by investment bankers, hedge funds, the speculative, not regulated by the FRB, subsidiaries of large banks and by the speculative arm of insurance giant AIC. This same group owned many of the mortgage bonds but many were also owned by more conservative investors, including, smaller banks, pension funds, university endowment funds and foreign governments.

The sellers of credit default swaps did not have funds to make good on the guarantees. This is what brought down AIC, Lehman Brothers, Merrill Lynch, and Wachovia as well as many hedge funds. They did not have the money to pay the guarantees because they violated the basic rules of sound risk management. Diversify. Buy reinsurance. Hold enough reserves in conservative investments for the worst disaster likely in any hundred year period. This was the hubris of MBA’s that they could manage risk better than insurance actuaries so that they could leverage their capital at 30:1 and borrow short-term from other highly leveraged lenders if they had a period of larger than usual claims to pay. When any one firm could do this, collectively they all can not do it at the same time because there will be no one to borrow from.

This delusion about their skills at risk management worked very well for several years during the post 9/11 recovery period when massive liquidity injections to spur spending kept capital relatively cheap and short-term credit rates relatively low and speculation and loosened mortgage lending standards pushed home prices higher and forestalled the inevitable foreclosures. This was an unusual period. It should not have been expected top persist for more than a few years.

The consequence is that they world has entered a several year period of financial de-leveraging. Debt to capital ratios of 30:1 and higher at non bank financial firms are being rapidly reduced toward more prudent ratios. This destroys $ trillions of capital and reduces lendable funds by the leverage multiple. Credit will be more expensive and credit standards will be higher. Capital investment will decline for several years in the US as loans outstanding come into line with lendable funds. Do not be mislead by the results of the initial fix to the financial crisis. The massive capital injections will balance loan demand with loan supply within a few months. But then the FRB, other central banks and government treasurers worldwide begin to withdraw the emergency funds they put in the financial system to minimize taxpayer costs and restrain inflation. Credit will be expensive and hard to get for several years.