When the US subprime crisis began, we were assured by the ‘experts’ that it was only a small problem, involving a minor segment of an otherwise robust market. However, the more one read about the situation, the more untenable this view seemed to be.
Equally, we were told by other ‘experts’ that there was no danger of any spillover into other countries. Again, this reassurance began to seem equally simplistic after it became apparent that subprime loans had in fact been parcelled up and sold around the world. But even when the IKB and Sachsen banks had to be rescued in Germany, other ‘experts’ rushed to tell us that this was really due to issues relating to the German banking system.
So one wonders what these ‘experts’ will rush to tell us today, on the news that the UK’s Northern Rock bank, responsible for 18.9% of UK mortgage lending, and with over GBP 100 billion in assets, has had to rescued by the Bank of England, acting as ‘lender of last resort’? Whilst we wait to be told not to panic, us non-experts are probably safe in drawing the following conclusions:
• The liquidity crisis in the banking sector is getting worse, not better. The underlying problem is that banks have been borrowing in the short-term money markets to lend long-term. This is very profitable whilst it lasts, but the US Savings & Loans collapse of the 1980’s is a reminder of how it can all go very badly wrong if short-term lending dries up.
• Banks are usually very keen to lend you money when you don’t need it, but are very quick to withdraw at the first hint of trouble. One doubts that other banks will rush to fill the void in the UK mortgage market that will be caused by whatever retrenchment now takes place at Northern Rock. So even normally well-qualified home buyers may find it more difficult to borrow in future.
• Housing has been a main source of support for the Western economies in recent years. Low interest rates encouraged more buyers to enter the market, and the laws of supply/demand worked to push up prices as a result. This allowed homeowners to release equity from their home via remortgaging, and kept consumer spending strong. This virtuous circle is now in danger of becoming a vicious circle, as lenders tighten standards to more normal levels again.
There is one ‘expert’, however, whose judgement I have learnt to trust over the years. Warren Buffett spotted the underlying risks posed by financial derivatives as long ago as 2003. He described them then as being ‘financial weapons of mass destruction’, and warned that they could end by creating ‘a mega-catastrophic risk’ for the economy. One just hopes he is not proved right.
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The Northern Rock crisis demonstrates how vulnerable financial markets are to the interdependence of financial institutions. It would appear that NR was not directly affected by the sub-prime crisis; they had not invested in any of the dodgy derivatives that are causing such problems.
However NR decided to expand their mortgage book (I understand by +50% in the first eight months of this year), a risky strategy in a housing market which had already seen such an enormous rise in prices. And NR did this by borrowing from banks which have been caught up in the sub-prime crisis.
These banks are suddenly finding big holes in their assets and can lend no more – and they too can be accused of acting recklessly. They may argue that they have abided by the rules but this is not an excuse. They have made dodgy investments using our money. Only constant vigilance by fund managers when they buy securities will prevent them falling into traps set by the greedy. They must look at what lies beneath.
I have written a simple explanation of how we got into this mess on this post:
http://www.thinkhard.org/2007/09/a-really-simp-1/