In august 2007, American, European and Asian indices have started losing value in what most economists call a burst of bubble. We have been able to see quick reaction of Citibank , which has quickly found new investors, even before the news of their loss has reached the general public. Other banks have not been so lucky and most people expect that there are many that have yet to fall.
Buying a property is an American way of saving. By paying off a mortgage, mortgagee is actually building value. Instead of paying rent, people pay a mortgage and own the home. When they pay off the mortgage, they own the whole property, which has gained in value in the meantime. Mortgages are easy portable and can houses can quickly be remortgaged with original mortgage being paid off if the market conditions change and rates become lower. Bank approves mortgages for purchase or construction of property, guaranteed by the said property. If mortgagee defaults on the mortgage, bank can repossess the property and sell it on the open market, for profit. Banks bundle such mortgages and create complex financial securities (collateralised debt obligations (CDO’s)) that they sell on to investors, thus offloading the risk and freeing the money for future lending. Due to this mechanism, Japanese and other foreign investors have enabled cheap bank financing of mortgages. Banks were able to quickly sell on all the mortgages, and hunt for new clients, new profits.
This has been going on for many years. Every year, there were less and less people that have fulfilled strict lending criteria. Because the banks have wanted to keep this source of income, they have found a quick and easy solution – lower lending criteria.
Apart from cheap prime mortgages, banks have started to offer a bit more expensive sub-prime mortgages for people with lower credit score. This erosion of standard has progressed so far, that, in 2006, new category of loans was created, so called Alt-A mortgage with stated income (later dubbed Liar Loans) that was never checked. We have also witnessed the division of the CDO’s into various tranches, where the lowest level took the first 10% of loss, a bit higher level the next 10% etc. This splicing has resulted into 85% of all CDO being classed as AAA by the rating agencies, thus converting very high yield/risk Alt A and Subprime mortgages into very safe, low yield securities that were then sold on to investors. Banks were happily skimming the difference and lending the money to even more customers.
All this creative solutions have sent very wrong economic signal to the construction companies. When there was enough property on the market, rising prices that have, at least partially, been the consequence of easy credit, have sent the signal that there is not enough property on the market. Because of the demand, construction companies have started many ambitious projects that have now stalled.
Due to the trick of securitisation, many institutions that have been restricted to only invest in high quality assets have been able to participate in the market. Even more, because this was classed as triple-A quality asset, many institutions have used leverage to boost returns.
Leverage is a simple instrument where we cover only part of our investment with our money, the rest we borrow. If investment returns more that the cost of money that we have borrowed, leverage enhances returns on our money. 1% growth in investment with 1:100 leverage returns 100% on our investment, because each move is enhanced 100 times. Exactly the same and opposite happens in case of 1% loss. In this case, we have lost all our initial deposit. If investment with such leverage falls for 5%, we owe 5x our deposit.
Exactly this mechanism has worked in case of collapse of mortgage securities. When property prices collapsed, we have seen a domino effect in leveraged instruments that contained at least some mortgage securities. Losses exceeded capital and financial companies were liquidated. Banks stopped lending money to each other, liquidity has been decreasing and crisis has been deepening. Banks and financial institutions that were deemed too big to fail have started failing.
Liquid banks with safer investments have been taking over banks that were solvent, but illiquid. Central banks have selectively started solving the crisis. Northern Rock in UK has been nationalised, JP Morgan Chase has, with government guarantee, taken over Bear Sterns, Fanny Mae and Freddie Mac have been nationalised, Lehman Brothers has been allowed to fail, Bank of America has taken over Meryl Lynch, the last remaining investment banks have asked for universal banking licence that allows them to collect deposits and gives them access to FED discount window, Insurance giant AIG has, in return for 79,9% stake, gotten 85 billion USD in emergency loans.
American government is preparing a stimulus package, where USA will create a bad bank that will purchase most of mortgage securities and thus both stabilise the market and clean balance sheets of banks, thus helping with the sanation of banking sector. In UK, the crisis has followed the American blueprint with around 6-month delay. Since the beginning of the crisis, USD has lost around 10% versus the basket of currencies, even though it started regaining some strength lately. GBP has loyally followed the USD on the way down, just like the property prices, even though, admittedly, a bit less.
In Europe, the crisis has been spread selectively. It has hit Spain very hard, as their Costa del Sol was a true construction bonanza, where prices have been reaching 4 or more times their construction cost. They were, of course, finance by 90+% mortgages that have suddenly ceased to become available. Construction there has fallen by more than 40%, which is quite noticeable both in the increase of unemployment and decrease of economic activity. Large European banks have also been busy writing off investments in American subprime. Despite that, we have not seen any large banking failures in Europe, apart from small German banks. There is so far no evidence that property prices have started collapsing throughout the EU, even though it is fairly obvious that, in current economic situation, they are probably not going to increase much anywhere in the world, apart perhaps in Russia that is basking in the money from Oil and commodity bonanza. India and China still continue with their high growth, but we can already observe early signs of slowing growth there as well.
In Eastern Europe, the crisis has so far not left any marks on the property market. In Slovenia, we do not expect serious collapse in property values. There is a big difference between property marked in Western countries and Slovenia. Despite that fact that property ownership is around 70% both in USA and Slovenia, the average value that is mortgages is 15% in Slovenia and 60% in the USA. If there were more properties built in the USA than there was actual real demand, this is not happening yet in Slovenia. High quality property still finds customers in Slovenia.
The crisis is far from over, and will not be the last crisis ever. Even though we hear dramatic words that value is being destroyed, underlying value remains unchanged in such crises. It only changes the owner and revalues. As long as there will be rewards for taking extreme risks, where the state covers the losses, and shareholders keep the profits (moral hazard), such booms and bust cycles will repeat themselves. Less than 20 years have passed since the collapse of Japanese property bubble. The consequences were huge, far reaching and obvious. On 29.12.1989, just before the crisis hit, Japanese index Nikkei 225 was worth 38916 points. On 28.12.2007, 18 years later, its value was 15307,78 points, a loss of 60%. On 22.09.2008, after the turbulent week of Lehman failure, its value was 12090,59, 69% less than on 29.12.1989. Can we expect something similar?
This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 28.9.2008. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6047
