Third Eye on the Third World

Date September 22, 2008

Author: John Mangun

BUSINESS MIRROR

http://businessmirror.com.ph/09252008/opinion02.html

“Outside The Box”

“The Financial Crisis: The Collapse”

From this column last Tuesday: “By mid-2004, the picture could not have been any better. The New York stock market had risen from 8,000 to 10,000 over 12 months. There was almost an unlimited amount of global funding for housing loans. Mortgage interest rates were at the lowest level in 25 years. Home sales had never been any higher”.

That is the backdrop of the near collapse of the US and Western banking system these last weeks.

From 2001 to 2005, buying a house was a guaranteed profitable investment. Hundreds of billions of dollars of lending nearly doubled the price of a house during those years. The lenders made huge profits fueling the housing boom.

The now infamous Lehman Brothers, one of the Financial Services Companies (FSC), saw corporate profits soar by 74% (2003), 39% (2004), 38% (2005), and 23% (2006). In 2007, profits rose 4.8% and now, less than a year later, Lehman Brothers is dead.

How could that happen?

The boom was built on a vicious circle, a complex series of events that reinforces itself through a feedback loop toward greater instability. Higher home prices means more loans which creates higher home prices that fuels more loans.

That economic model is simply a pyramid scheme.

Housing prices continuing to go higher was dependant on lending. The loans used the houses as collateral and the loans being solvent were dependant on home prices going up. As long as new buyers were able to get new loans, the boom would continue. By early 2005, the conditions that boosted the property sector (and the FSCs) from 2001 to 2004 were about to end.

In order to keep home buyers coming in, new loans had to be generated and this was accomplished by lower lending standards. Furthermore, more money was needed to fund the lending so bigger and more complicated loan ‘packages’ were created to attract global institutional money. Continued lending and the boom times depended on three critical factors.

The first was that home loan interest rates stay very low so that almost anyone could afford the monthly amortization. In order to make that amortization as low as possible, a large percentage of the loans, nearly all the ‘sub-prime’ loans, were ‘variable rate mortgages’ (VRM). The interest rates on VRMs are based on prevailing rates that change and perhaps go higher if general interest rates increase. ‘Fixed rate loans’ are higher than prevailing rates but the rates never change. From 2001 to 2204, interest rates were at historic lows.

From August 2004 to July 2006, interest rates increased every month going from 1% to 5.25%. Over this period, the cost of monthly amortization increased and thousands of these new homeowners could no longer afford to pay their loans and the FSCs found themselves with millions of dollars of loan defaults, with the amount growing rapidly. As buyers defaulted, the banks now had thousands of houses in foreclosure that suddenly flooded the market, stopping the rise of home prices. Housing prices peaked in January 2005.

The second factor was home loan borrowers be able to keep paying their amortization. But over a short time, oil prices doubled and people did not have the money to pay their loans. In January 2004, a barrel of crude was selling at $30. By mid-2006, consumers were paying $70. By mid-2007, prices took off, reaching $147 in 2008. Too many of the housing loans made from 2004 to 2006 were made to people that did not have the extra income to be able to fund their loans and also buy high-priced gasoline. More foreclosures hit the market.

The third critical factor was that the Dollar remain strong. In order to find the enormous amounts of fresh loan money needed, the FSCs looked overseas for new investors and sold Dollar-denominated loan packages. In January 2004, the Dollar Index, which is the value of the dollar against a basket of major foreign currencies, traded at 88. By May 2004, the index was at 90 and the foreign investors were making a killing on both the loans and the foreign currency rate. The interest rate they were receiving on their investment was good and the dollar was strong. From 92 in late 2005, the dollar bottomed out in April 2008 at 71. The lenders, which included great numbers of foreign banks, pension funds, and other financial institutions, were not only experiencing large payment defaults from their ‘investment packages’, but they were also losing money on foreign exchange rates.

The start of 2006 was the beginning of the end for everyone. Interest rates skyrocketed, high oil prices damaged borrowers’ finances, and the falling dollar affected foreign funds for lending. Home sales and housing prices had topped out. Housing loan defaults were accelerating. The housing/credit bubble was bursting because the pyramid scheme could not bring in new players.

The last loan packages created in late 2007 were filled with loans that eventually defaulted causing huge financial losses to financial institutions all over the world. By mid-2008, the Western financial system was in deep trouble. The incredible corporate failures you have read about are because these companies do not have enough cash to fund their operations or to pay back their clients’ investments and deposits. These firms are holding their share of the hundreds of billions of dollars of non-performing loans, near worthless loans, backed by near-worthless collateral (houses) that have lost a large portion of value, and worse, cannot be sold for cash.

// posted by john mangun @ Saturday, September 27, 2008