August 12, 2007

All the cheap credit went to our heads; now we must pay the bill

Posted in Banks · 11 comments ·
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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.


  1. Paul H

    On a seperate issue to the above article. The closing of 2 Dublins hotels is in the news headlines today. Anyone interested in this story should read the article below, which is the best article on this site in my opinion.

    Fate of Killiney Court Hotel shows the free market at its very worst.

  2. mark mc

    good work David, but who decides these actions on behalf of the central banks? if any other private business colapses then there is nobody to bail them out? seems to me that the governments are not in control, its the bankers. also good to see leeds getting 15 points taken off from the beginning of the season.

  3. Paul R

    David,
    this whole scenario has been predicted by The Economist (and by yourself) for at least the last two to three years so the bankers who have caused it (and the regulators who have allowed it to develop) really have no excuse. When will people ever listen to reason. Keep up the good work.

  4. Weve used the old hair of the dog trick since the Sept 11th attacks we have delayed the hangover for so long that its gonna be a legendary come down!

  5. Ciarán Mc

    Hi David,

    You’ve mentioned a few times recently about the US interest rates being slashed in response to sept 11th. Looking at the US rates, I’m not sure that is factually correct. US rates hit something of a localised peak around the middle of 2000, where they were the highest they’d been since 1991. In the 12 months following Sept 2000 (not 2001) there was a long series of cuts which saw the rates slashed back by about half. While it is true that rates continued to fall after Sept 11 – and undoubtedly the profound nervousness caused by the events of that day made Fed err on the side of bolstering confidence — it can hardly be said that the date marks the true beginning of the decline towards cheap credit. In fact, by the time the two towers were struck, the American economy had already hit its (historically speaking) mild recession. It seems this dip began in late 2000 – it had nothing to do with Sept 11. Therefore the rate changes were a response to a recession that was already underway. Of course, the terrorist attacks prolonged it and resulted in rates staying lower for longer.

  6. MB

    The problem with this financial crisis is that it could all have been halted in its tracks much sooner – if there had been better rating of asset classes and better regulation of lending practices in the US and Irish banks, we would never have seen it come to this. There is now talk of the US Federal Reserve cutting interest rates to try and dampen the effect of this crisis. If there had been quicker action to regulate infationary lending from the beginning, however, then they would never be in this position. Irish banks have been lending like madmen for the last 5 years with people getting all kinds of crazy mortgages on poorly-valued assets that should never attract investment. I heard of people even three years ago getting mortgages that were 10 times their income with the bank assessing them as good for the money based on the idea they could rent out one or two of the rooms in the house for additional income. That kind of craziness was bound to lead to headaches. Now, unfortunately, governments and central banks have let it get so out of hand that it threatens the whole world economy, and the housing crash in particular threatens the Irish economy.

    It’s been going on for too long already but instead of learning from the current crisis and looking at better regulation of lending and hedge fund activity, central banks are instead just contemplating yet another rate cut solution, a blunt instrument that will just set off another bout of crazy, high-risk lending. And the ECB is just propping up the market with its injection of funds – it would have been better if it followed the BoE model in the UK of allowing banks to apply individually to centralised fund for support in a crisis, rather than pumping the market full of more cheap money to fuel more high-risk lending.

  7. Dan Hayes

    David & Co.:

    While banking community greed was probably the main motivating factor in the American-induced debacle, there is another component specific to the States which usually goes unmentioned. Namely the drive to extend cheap-cheap mortages to creditwise unworthy Minorities (who of course are fast becoming Majorities over here). So chalk this up as another manifestion of Politically-Correct Economics (or actually MisEconomics).

    Greed and Political Correctness are a Witch’s Brew!

    Dan

    P.S. While you in Ireland are blessed with beyond the Pale politicians and a collapsing housing market, at least you don’t have to endure the oppressive H&H (heat and humidity) of New York City in August. Cheers!

  8. bah – its uncomfortably humid here and rainy all summer and because its not opressive we have NO aircon – you get NO sympathy from me ;-)

  9. Steve

    Regarding Dan’s comment above on the witches brew. I thought I’d revisit a piece Shakespeare :-)

    The Tragedy of MacBank
    By Steve D.

    Round about the Cauldron go;
    In the poison’d Entrails throw.
    Hair of horse from Galway Races,
    Wetted whiskers from builder’s faces,
    Envelops brown and illicitly got,
    Boil thou first i’t the charmed pot.

    Banker-auctioneer secret handshake,
    In the Cauldron boil and bake;
    Cheap money and champagne cup,
    Charts of prices going up.
    Media spin showing panic
    Safety plans for ol’ titanic
    For a Charm of powerful trouble
    Like a Hell-broth spawn the bubble.

    Athiest tongue and immigrant boot
    Population growth to permute
    Land development planning tactics
    Banker’s party prophylactics
    And wretched crab from Irish sea-
    clutching in its brimey clickers
    A Dublin hooker’s frilly knickers
    Add thereto a Tiger’s Chaudron,
    For the Ingredients of our Cauldron.

    And thus MacBank did the nation charm
    to strike it rich and raise above harm.

  10. okaycuckoo

    The crazy lending is all over – or it will be once the lenders have exhausted their approved product lines.

    Watch out for Crazy Prices! style marketing as they try to clear those lines, leading to a spike in mortgage applications.

    And mortgage interest rates will go up regardless of the rates set by Central Banks, because the credit market is factoring up on risk protection.

    Ten years of craziness, and all of a sudden – Crunch!

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