Credit Crunch Explained - A Guide for Beginners
Imagine going into your local Tesco one day to find that the greater part of the store had been given over to milk products such as butter, cream, yoghurt and cheese. Not only that but you also learn that the public are barred from this area as all trade is restricted to other supermarkets. Just as a large carton of assorted milk based goods exits the front door on its way to Sainsburys another one is coming in via the back, courtesy of Morrisons.
Well the world’s major banks seem to have been operating a similar business plan for the last few years. They have been buying large bundles of securities know as CDO (collateralised debt obligation), such as all of a particular credit card provider’s accounts receivable for say, Wigan, and at the same time, a matching bundle of a different kind of security such as shares in Northern Rock, These last are usually known as ABS (asset backed security) and there is a theory that says to spread the risk with a mixed portfolio of different sorts of investments like this is a good thing. If the credit card debts (CDO) hit problems then the Northern Rock shares (ABS) will shore up the gaps or vice versa. However, either this theory has been grossly misunderstood or it is just plain wrong.
The return on these bonds was supposed to be higher than the banks' usual yield, with the added advantage that they didn't have to perform any kind of service on behalf of their customers in order to earn it. How they made the money was to buy these bonds and either wait a long time for the cashflow from them to deliver the profit or take the preferred option by selling them on at a premium to other banks. For years the banks have assiduously traded these instruments between themselves as they took on a value all of their own especially if interest rates were either going down or expected to do so, thereby freeing up cash in order to buy a new lot.
The real villain of the piece though has been the MBS (mortgage backed security), which took centre stage from the early 2000s. This was at a time when the house price boom was getting underway in the US, as was ours. Everybody was invited to this particular party, including a lot of people who in the long run couldn’t actually afford to join in. Subsequently an MBS would then be concocted from differently rated mortgage debts; some good, some bad, some indifferent and some downright lousy, or sub-prime as they are now called. An ABS mix of say, shares and hire purchase debts was added as a hedge against the chance that some of the components might not perform and once one of the rating agencies had given the whole package the nod it was offered to the banks.
They all joined in and it would appear that some of them such as UBS, Morgan Stanley and Merrill Lynch couldn’t get their hands on them quickly enough. Then as interest rates rose and the profit margins evaporated, the wheels started to come off these trades. That was when the realisation dawned that US mortgages, Wigan’s credit card debts and Northern Rock shares were actually all made from milk; which had come out of a cash cow called the housing market.
The credit boom of the last few years was riding on the back of ever increasing house prices and it was this that was driving just about everything from consumer spending to share prices. If prices stopped going up the credit boom would stop; causing everything else to stop too and thanks to rising interest rates this is exactly what happened. Sub-prime mortgages were the first to sound the alarm as defaults and repossessions in America rose sharply and in the event that was all it took for most banks to take a closer look at their balance sheets than usual and realise that they had traded themselves into trouble. At this point the securities market hit a brick wall, which is pretty much where it remains at the moment. What the banks had failed to realise is that when a product passes it sell by date it goes sour and they are now discovering that when you keep it on the shelf for too long after that, it starts to stink.
Click here for a definition of MBS (mortgage backed security)
Click here for a 'thisismoney.co.uk 'definition of Alt-A (Alternative 'A' rated home security)
Click here for a definition of CDO (collaterised debt obligation)
Click here for a definition of ABS (asset backed security)
Click here for a Guardian article on the FBI investigation into the sub prime crisis
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