August 12, 2007
All the cheap credit went to our heads; now we must pay the billPosted in Banks · 11 comments ·
The chaos of the last few days in the financial markets is the upshot of making profits from lending money to people who cannot afford to pay it back.
Last Thursday, European financial markets woke up to the reality of risk again. Investors who had been happy to believe the hype got nervous.
They started withdrawing money from dubious funds that had promised fantastic returns, if you could just ignore the basic fact that the people to whom you were ultimately lending money, had defaulted before, had dodgy credit ratings and could well default again.
So if you could disregard the risk and simply look at the promised returns you could make a fortune. This is investment made simple. And it is now coming back to haunt the financial markets.
For two days in a row, the European Central Bank had to step in and lend money to banks that were haemorrhaging cash, as investors demanded their money back.
The panic was causing interest rates on the money markets to rise and the Central Bank, doing its job, tried to calm fears. Central banks across the world — from the US to the Far East – did likewise. This may have calmed the markets, but it also served to underline that something serious was going on.
Why is this happening? For this scribbler, there is a strange sense of deja vu because BNP Paribas – a French investment bank I once worked for – prompted the panic by announcing that investments in the now-infamous sub-prime mortgage market were going sour.
Nine years ago this month, the same bank had similar problems in Russia, when the ailing government of Boris Yeltsin decided that it could not repay its debts.
Even though there appears to be no similarity between the last days of a kleptocratic regime and the problems in the sub-prime mortgage market, when you look at them a bit more closely, these events have much in common.
Both stories involve investors who, beguiled by a few boom years, take one risk too many and banks, driven by greed, abandon all behind-the-scenes credit control.
Once a bank abandons risk controls, it ceases to be a bank. The reason the Irish market is falling more sharply than all other markets is because investors are worried about the lending practices of Irish banks.
They have read the warnings about the Irish property market and they are worried. The borrower does not need to have the obvious risk profile of Boris Yeltsin to default. Irish bank share prices have lost around 10 per cent in the last two days and are now 20 per cent below their peaks for this year.
The global and Irish story begins and ends with cheap credit. In recent years, the global economy has become awash with cheap credit. In the wake of September 11, 2001, interest rates were slashed by central banks worldwide to try to revive the international economy.
The base rate in the US fell as low as 1 per cent. As long as the central banks weren’t worried about inflation, they presided over a massive money printing operation.
An easy way to imagine how lucre gets divided up by the banks once it cascades into an economy is by thinking about a champagne pyramid. Imagine a tacky wedding with a pyramid of champagne glasses and a blushing bride who begins to pour from the top.
Eventually, the champagne finds its way into even the most remote glasses (the guests who have only been invited to the afters) as it overflows down the pyramid. As each layer of glasses fills up, the next layer begins to do likewise.
Now think of the Irish financial markets. When the Irish banks turn on the credit taps, it is the equivalent of popping the cork of a jeroboam of champagne. Credit flows initially into the top, triple-A assets, such as a loan to a blue chip company.
Then this market overflows, so the excess cash finds its way into other, more risky, assets. As these fill up with cash and yields fall, the speculative cash goes further afield looking for return.
Eventually, as long as the taps remain turned on, even the riskiest projects, regions and ventures get cash. Two-bit developers slapping up townhouses in rural wastelands get some of the action, as do sub-prime borrowers who wouldn’t get a look in had it not been for all this cheap money.
For awhile everything is hunky dory. The risky borrowers pay back the cash and the bank seems to be making money for nothing.
Then someone fails to make a payment, then another person defaults and the system begins to feel creaky. So the banks react by cutting off the champagne flow.
But these only make the credit crunch at the bottom worse, because, like the empty champagne glasses at the bottom, there is no new money replenishing the old stuff. So, starved of their new-found credit, the people at the bottom default in droves.
This is how a small problem becomes a major panic. And with the interconnectedness of the international financial markets, a problem in the US can knock on to European financial markets, as we have seen dramatically over the last few days. Defaults by poorer mortgage borrowers in the US have knocked on to chaos on the European markets.
If the European Central Bank lends enough money to the jittery market, things should stabilise for now. This is what we should all be hoping for. However, the underlying weaknesses in the global financial markets will not go away.
And it is the sub-prime people at the bottom, like those at the bottom of the champagne pyramid, who are about to realise that, not only is their glass not half-full, but that they are running on empty.