A Special Report on the Financial Crisis

by Sharon Bowles MEP

The Start of the Crisis

The underlying problem has been easy credit for many years.

Full analysis of this is complex, but there is no doubt that increased standards of living and home ownership for the less well-off portion of society have resulted from innovation in lending practices.

However it escalated too far with practices in many areas of the financial sector falling short of what it should have been. This includes substantial failures in supervision as well as in the financial institutions themselves.

The US Contribution: Sub-Prime Mortgages

The mortgage market in the US involved too many bad loans given out to people unable to pay them back.

The 'last straw' that triggered the turmoil was a large number of dodgy (sub-prime) mortgages in the US.

These dodgy mortgages were being given to those who could not afford to repay them and without any deposit element. Loans that are backed by a charge (such as on a property, known generically as collateral) are an asset because they provide an income from the repayments. There is also the underlying value of the property in the event of default. So loans can be held as an asset or sold on to others. It had become an encouraged banking practice to sell the loans on by packaging them up with other mortgages (safety in numbers) and selling the package in slices, some being very good slices and some not so good (so-called securitisation). Sometimes this pool and slice process was repeated so the product became very complex.

Purchasers of the securitised loan products knew the type of slices they were getting by taking note of the ratings (done by Credit Rating Agencies). However, as the purchasers were other financial institutions they should also have done their own research or 'due diligence' on the nature and safety of the asset they were purchasing. Likewise supervisors of financial institutions are supposed to understand the assets of the institutions that they regulate.

It then became apparent that the real bottom end borrowers had a different attitude to their mortgage than had historically been the case. Instead of doing everything to hang on to their property by paying their mortgage, they walked away and defaulted because they had no equity to lose.

This put more property on to the market and house prices fell (a slow down in house prices in the first place also helped to trigger the chain reaction). Remortgaging using the increase in value in property to pay off mounting debt ceased to be possible and a vicious circle went round and round.

The higher rate of default than had been expected in the rating agency models led the rating agencies to lower the ratings on the slices of loans (the so called collateralised debt obligations CDOs or more accurately a subdivision of them called Retail Mortgage Backed Securities, RMBSs, now more generally called toxic assets). There was criticism that the Rating Agencies were too slow to downgrade, but the real mistake they made was basing all their modelling on historic US housing trends. Thus they assumed for example that different regions in the US would not all see a fall in prices at the same time.

The Banks

Reducing the ratings of the 'securitised loan assets' made them worth a lot less, and where they had been used for further security, there was now fear of default.

Such was the level of complexity of some of the packages that had been through the pool and slice process more than once, and it has to be said sheer lack of due diligence by purchasers, that nobody seemed to know where the bad stuff was and everyone became frightened of doing business with other banks in case any of the collateral they offered was contaminated. This was further exaggerated because the 'monoline' insurance companies that specialised in giving insurance to these kinds of products became overwhelmed by the volume of default and so sufficient insurance was no longer there (one of the reasons for AIG going under eventually). Other ways of the banks raising money (the money markets, see below) also dried up. This was the start of the credit crunch at the inter-bank level.

Although the level of defaults went up, it was by a few percent so the assets were not valueless, but they were uncertain. However for those who needed to be able to use them for trading or collateral they were effectively without value. Under accounting rules, assets have to be valued at a market price (mark to market) so now a lot of assets became valued at almost nothing, so this triggered a lot of write offs on bank balance sheets, leaving them with inadequate capital reserves.

So they had to raise funds and grab everything they could and part of that was stopping lending to ordinary businesses and individuals. This was the start of the credit crunch for the rest of the economy.

NEXT: Everything Gets Worse.

Page 3: What Europe Does Now.