Did we learn anything from the credit crisis?

By Robert Owen, Managing Director – Mortgages and Bridging

People remember the start of the credit crisis in different ways. For some it was BNP Paribas’ disclosure in August 2007 that it had no idea how much it’s sub-prime investments were worth. For others, it was the realisation that the central banks for weeks had been pumping billions into the financial system to calm nerves and try to keep the Interbank market working. For most people in Britain, especially those who weren’t avid readers of the FT, it was the images on the 6 O’clock news on the 14th September 2007 of long queues outside branches of Northern Rock which first alerted them that something big was happening.

Much of the blame for the credit crisis has been laid at the feet of bankers, especially those involved in the securitisation of mortgages.   It was a technique developed in the US during the 1980s with the backing of the guarantee companies. Loan portfolios were packaged into tradeable bonds known as Mortgage Backed Securities (MBS) without too much attention being paid to the quality of the underlying asset, or the need for the original lender to provide a first loss position should the mortgages default. In other words, the risk of loss ended up with often unsophisticated bond investors who didn’t ask enough questions. Sub-prime loans to borrowers who, by most modern measures, should never have been granted a mortgage were securitised, bringing in investors’ money which could be fed back into the sub-prime mortgage machine. It became a lucrative and vicious circle.

The US Government provided plenty of encouragement. President Bill Clinton’s 1995 National Homeownership Strategy was designed to help millions of Americans become homeowners, particularly those who until then would struggle to get a mortgage. Lenders and the guarantee companies, Freddie Mac and Fannie Mae were spurred on by increasing targets set by the US Housing and Urban Development Department to provide loans to low income borrowers. Between 2001 and 2004 they were told to make 50% of their loan guarantees to people on low to moderate incomes and 20% to those on very low incomes. Political encouragement came directly from the White House. In 1989 only 1 in 230 US homes were purchased with a 3% deposit or less. By 2007 it was 1 in 3. It didn’t take much of a dip in house prices to cause hundreds of thousands of homeowners, mortgaged to the hilt and now in negative equity, to simply walk away from their homes and their debts and leaving the lenders to sort out the mess. Under normal circumstances it would probably have remained a US problem. However, the reason this sparked a global credit crisis was because although these mortgages had been securitised and sold on as MBS bonds, a few banks, such as ABN Amro, Bear Sterns and Lehmans, had been buying MBS and held large loan portfolios which had not yet been securitised.

Bankers then decided they could make MBS issuances more efficient by taking the most risky, subordinated bonds from a number of different transactions and by packaging them together they had them re-rated to create a portion of AAA notes through the issuance of Collateralised Debt Obligations (CDOs). Now banks and investors all over the world could satisfy their appetite for a higher return by buying highly rated bonds based on sub-prime mortgages secured on homes all the way from Alabama to Alaska. Homes the owners really couldn’t afford.

Up until the early 2000s CDOs were generally well diversified and the portfolio theory which supported the way they operated was in evidence. However, as the noughties progressed, the appetite for CDOs became so great, and the source driven mainly by the US housing market so plentiful, that they became more and more weighted towards sub-prime home loans. When US house prices started to fall in 2007, and the subsequent mortgage defaults grew quickly, CDO values plummeted.

Many US subprime loans had initial teaser interest rates and for many years borrowers were able to frequently refinance the loans, which resulted in them being able to continue to benefit from the lower teaser rates.  However, when the market froze these borrowers were unable to refinance with the result that their mortgage payments increased materially and this increased defaults. It was the junking of CDOs which sent waves of panic into the boardrooms of financial institutions around the World. On the 9th of August 2009, BNP Paribas blocked withdrawals from three of its hedge funds because of what it described as a ‘complete evaporation of liquidity’. Although the bank said it was a temporary technical issue the interbank system froze. BNP Paribas weren’t alone. Most of the major banks were up to their neck in investments linked to the US housing market and seeing stormy waters ahead decided to hoard cash rather than lend it.

With no money in the wholesale funding market one UK lender found itself particularly squeezed. Northern Rock was an incredibly successful mortgage lender and it relied on wholesale funding for around 50% of its funding, not a bad strategy when the banks were lending to each other. Contrary to popular belief, it hadn’t been making thousands of bad loans, it simply couldn’t find the money it needed to keep lending and it was also one of those banks keen on purchasing MBS. On the 14th of September 2007 it sought and received a liquidity support facility from the Bank of England. As news broke the queues started to form outside the branches. It was the first run on a British bank in 150 years.  The question of course is should the Bank of England have done what central banks normally do, which is to swiftly provide short term cash at punitive rates to those banks which needed the liquidity? Or is there a moral hazard in doing so? That was the position taken when Lehman Brothers was forced to declare itself bankrupt in September 2008. There was no denying that we were in a full blown credit crisis. Unfortunately, Gordon Brown’s, promise as Labour Chancellor “that there would be no return to boom and bust” proved to be one he couldn’t keep.

So what have we learned and can we avoid another global financial crisis?

Mark Twain is often attributed with the saying that ‘…history doesn’t repeat itself but it often rhymes…’ and the one thing we can be certain of is that at some point there will be another financial crisis. We can also be reasonably sure that the next one won’t be caused by the securitisation of mortgages. This certainty is not so much derived from the imposition of greater regulation, so often the closing of the stable door, but because bankers didn’t so much get their fingers burned by the credit crunch as had them charred to the bone.

Consider this. The desire to own and trade unusual tulips created a huge financial bubble in Holland between 1634 and 1637. Although tulips were already popular, a non-deadly virus developed in the Dutch bulbs which created unusual colour patterns on some of the flowers and traders and individuals liquidated life savings and property to buy the rarer bulbs. In 1637 a single bulb sold for 6700 guilders, enough at the time to buy a house in Amsterdam beside one of the smartest canals. When the madness eventually stopped, even the Dutch government stepping in to guarantee 10% of the value of existing contracts couldn’t prevent the price plummeting further. Many investors lost everything. Suffice to say, we’ve not had another ‘tulip bubble’ since, despite the tulip bulb market seeing little by way of financial regulation.

Today, securitisation properly diversifies risk and requires the originator to take a first loss position, and thereby an interest, in the on-going performance of the loans.  In addition, banks are subject to more stringent capital rules, which reduce the probability of another Northern Rock. Affordability tests prevent lenders from providing mortgages to customers who cannot afford them, self-certification has been banned in some countries (the UK in 2013) and from Jan 2019 self-cert loans cannot be securitised (Article 17.2 EU securitisation rule). All these changes are good. But there will be something else in the future which pushes the financial system to, or close to, breaking point.

As JK Galbraith points out in his book ‘A Short History of Financial Euphoria’, when you are in the midst of a financial crisis, it always seems far worse than the previous one, and this time the world will end! Although the last ten years have been tough for many people in the UK, as a result of austerity measures, the recession was very different to the one of the late 80s and early 90s. Back then the volumes of repossessions were painfully high. In 1991 there were 75,540 mortgage repossessions and, even though the number of mortgages has mushroomed, the number of repossessions haven’t been anywhere near that figure since. In the second quarter of this year there were just 1,800 mortgage repossessions.

Perhaps the most important outcome of the credit crisis has been the increase in caution amongst sensible bankers. It doesn’t discourage them from taking a reasonable and well-judged risk, but they do get slightly uneasy in the tulip bulb section of garden centres.