This pandemonium will hurt us all
Published 16 August 2007
America's housing bubble has burst: it's the price of making easy money from the poorest in society, and we could have seen it coming
Two years ago, in a valedictory speech at the exclusive monetary symposium in Jackson Hole, Wyoming, Alan Greenspan issued a stark warning about prospects for the US housing market. Soon, the then outgoing head of the Federal Reserve argued, the "boom will inevitably simmer down . . . house turnover will decline from currently historic levels . . . prices could even decrease".
Despite Greenspan's unchallenged reputation for being the best reader of the American economic runes, very few people were listening. When markets are booming and credit is easy because of low interest rates, and there are pots of easy money to be made from mortgage lending, no one really wants to hear the bad news. Yet often it is at the highest point of the economic cycle that the most serious mistakes are made.
Lenders such as Britain's HSBC, owner of Household International in the United States, saw US mortgages as a golden opportunity. People across the country were clamouring to climb the housing ladder and not be left behind in the boom, so who were these home-loan providers to get in the way? Besides, the best money was to be made from the poorest sections of society - America's "trailer trash". The less security and income a borrower has, the more they can be charged, and the higher the profits.
Even better, the financial super-brains in New York and the City of London had come up with a brilliant way of sharing the risk in the loans to the so-called "sub-prime" mortgage market that they were making. The mortgage debts, offering better-than-usual returns (because of the low quality of the borrowers) would be packaged up into neat parcels - known technically as "collateralised mortgage/loan obligations" - and parked with banks and investment funds around the world.
All this was fine when housing prices were affordable and interest rates were low. But no sooner had Greenspan spoken than the housing bubble burst. Prices across the United States plunged. Housebuilders were left with unsold stocks and the sub-prime mortgage lenders found not only that they had lent funds to people who had no realistic prospect of paying back, but the securities against which they had lent were worthless. HSBC alone lost £5bn.
Worse was to come. For much of the past decade, the assumption has been that inflation is in the past. International money markets had priced this into their thinking. It became possible for financial institutions to borrow money for five, ten, even 20, years at a cheaper rate than for six months, or even overnight. But this year perceptions began to change dramatically. A prolonged period of higher energy prices, together with strong demand from the newly industrialised nations of Asia for commodities of all kinds, sent the price of money to new peaks. The bond markets started to correct, and longer-term borrowing once more became more expensive. The financial groups that had borrowed cheaply suddenly found the cost of transactions had risen sharply, and several became uneconomic.
But in most cases the risks had long passed on from the originating institutions. The investment banks such as Goldman Sachs, Barclays Capital and Bear, Stearns & Co repackaged debts of all kinds, including sub-prime mortgages, into derivative products known collectively as asset-backed securities. At a time when wealthy investors were looking for ever better returns, these securities were snapped up by the new-wave hedge funds looking for supercharged returns.
Such vehicles - Goldman Sachs's Global Alpha fund, for instance, and several operated by Bear Stearns - were able to extract the maximum value from securities by borrowing against them and selling them on. Fabulous returns were made using sophisticated computer models. But as the sub-prime mortgage situation became worse and such lenders as the giant Californian company New Century Financial collapsed into bankruptcy, it dawned on nervous investors that the emperor had no clothes.
Billions of pounds, dollars and euros were withdrawn from sophisticated investment funds which admitted that they had no way of measuring the underlying value of their assets. The problem spread from sub-prime loans to those that had been used in private-equity buyouts. The panic spread across to shares, and central banks - fearful of the impact on the global economy and growth - flooded the markets with cash in an effort to avoid further collapses.
The resulting chaos has brought finance ministers, including Alistair Darling, rushing back from holiday, and has led investment bankers to abandon their yachts or the Hamptons and return to their offices in an effort to quiet the pandemonium. All of us will be hurt in the process, through our pension funds, insurance policies, a slowdown in global output and the risk to jobs.
Alex Brummer is City editor of the Daily Mail
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