The Credit Crunch - What actually caused our recession?

In one way or another we have all been affected by the recession. It is a topic that has been exhausted by the media, film, art, books, university lecturers and banter amongst friends down the local boozer. There are clearly many different opinions as to what caused this economic recession. I have heard family, friends and colleagues use many recognisable sound bites such as: the credit crunch, the War in Iraq, September 11th, Subprime mortgages, bad lending, the banks, the government and the list goes on. I decided to do some research and try, in my own words, to summarise objectively what has really happened to our economy.

Perhaps the best place to start is to clarify the difference between the Global Credit Crunch and a recession. Some people are under the illusion that both are the same thing. A credit crunch is simply the result of the banks becoming too nervous to lend us money and to each other. The irony is that this is usually the direct result of bad lending in the first place but we can come to that later. A recession is defined as two quarters of negative growth. It is essentially an indicator that the economy has slowed down. This is a result of people spending less, which causes jobs to be lost and even less money spent, spiralling the economy downwards. The credit crunch and the recession are obviously linked, with one causing the other. The media especially, have been quick to pass the buck of blame on to the banks. Perhaps in order to comprehend how the credit crunch happened, it is important to understand the concept of modern banking.

Banking in the UK can be traced back to the 17th Century. Goldsmiths were arguably the first real bankers and after the dissolution of monasteries by Henry VIII, began to accumulate vast stocks of gold. Many goldsmiths were associated with the Crown but following a seizure of gold held at the Royal Mint in the Tower of London by Charles I, they offered their services to the gentry and the aristocracy, as the Royal Mint was no longer deemed a safe place to store gold. Goldsmiths would keep the gold of wealthy merchants safe and give them notes of ownerships to exchange at other branches, the first bank notes. The goldsmiths had an epiphany moment, when they realised that the average customer only withdrew about 10% of their gold in any one year. They realised they could lend out the remaining gold at interest, in order to profit from their customers' gold deposits. So for every ounce of gold deposited, Goldsmiths were able to lend 10 ounces of gold and make interest on it. They realised they could secure property and all sorts of other assets against the loans, creating money out of thin air. The modern banking system was born. It might seem tempting to blame the bankers themselves for this system but it wouldn't have been possible if it wasn't for the obvious demand for credit. The only flaw of this system, is when credit is given to people who can't afford to pay it back, at the rate it has been lent to them.

Fast forward to the 2001 dot com bubble bursting and September 11th. Initially the costs of the terrorist attacks were borne disproportionately by a few industries, especially airlines, tourism and insurance; small businesses in the target areas and the City of New York as a whole. Not even thinking about their tragic impact on human life, the effects of the terrorist attacks were too small to significantly impact the USA's overall economic output. The events were too geographically localised to cause a national recession, unemployment rose much more sharply in New York compared to the rest of the country. What it did cause, however, was a crisis in consumer confidence and led to the Federal Reserve, which sets interest rates in the US and in a way for the world, to lower interest rates to as little as 1%. This caused a sharp fall in the cost of money and the supply of credit soared because the great exporting countries such as China, Japan and the Middle East were amassing vast surpluses of cash, which they could lend back to the west. It suddenly became cheap to borrow money anywhere. Leverage became common place and potentially explains the next step in the chain of events.

Leverage simply means borrowing to invest. During the last decade it was common place for people to borrow more against the already inflated value of their assets. For example, when we borrow for a mortgage we are leveraging. Take this common scenario a few years ago when the property market was booming. If I put a 10K deposit on a 100K home and borrow the other 90K and the cost of the house rises to 110K, I have doubled my initial investment to 20K, a 100% profit. The magic of using the banks money means the more you borrow, the more money you can make. This set a very dangerous precedent, because it only takes a batch of bad credit to cause a ripple effect on the market. Take a bow ladies and gentlemen, Mr Subprime.

Subprime lending simply means making loans to people who may have difficulty keeping up with the repayment schedule. Therefore a subprime mortgage or a subprime credit card is a loan given to someone that has a bad credit rating. Another term commonly used is a Ninja loan; no income, no job and a no assets loan. The Investment Banks realised that the Building Societies giving people mortgages, wanted to keep their books clean and so the Goldmans, Morgan and Stanleys and JP Morgans of the world discovered they could take on this debt and repackage it into financial securities they could then sell to investors. A Mortgage Backed Security or an MBS, is similar to a Bond but created from mortgage debts. A CDO (Collateralised Debt Obligation), is created by bundling a bunch of people's mortgages and putting them into different risk classes or tranches. Lets say for arguments sake you have three different entry levels to invest in; tranche A, tranche B and tranche C. Tranche A would mean little to no risk, B would mean medium risk and C a high risk. In theory the banks are supposed to pay a ratings agency such as Moody's or Fitch to rate the risk of each person's mortgage or credit, so that they can be categorised properly. But what would happen if instead of doing this, they cut a few corners and simply mixed the bad eggs (subprime mortgages) with the good eggs. The subprime mortgage crisis was caused by doing exactly this, 'bundling' American subprime and American regular mortgages, which were supposed to be sold in separate markets. The rate of return in theory looks superb to an investor, as subprime borrowers pay higher premiums and the loans were secured against saleable real-estate so theoretically could not fail. But finally and perhaps inevitably, such borrowers began to default in large numbers.The inflated housing market bubble burst, property valuations plummeted and the real rate of return could not be estimated. Therefore, confidence in these financial instruments such as CDOs collapsed and were almost worthless and considered to be 'toxic assets', regardless of their composition or performance. This caused banks such as Lehman Brothers to declare bankruptcy as they were heavily exposed to the subprime mortgage crisis, as their books were littered with these toxic assets. When Lehman's was allowed to fail, (beautifully parodied in the film Wall Street, Money Never Sleeps) the governments of the world realised they had to bail out the rest of the banks to stop the financial markets collapsing. Cue the media frenzy that followed and negativity towards the bankers, we needed a scape goat and we found one.

So who is actually to blame for the mess we find ourselves in? Do we blame the origins of the banking system that encouraged lending? Do we blame the terrorists for September 11th who caused the world to panic and the Federal Reserve to keep interest rates low, making credit cheap and readily available? Do we blame the banks for failing to properly create financial instruments that caused the market to implode? Do we blame the governments of the world for not regulating the banks properly? Or do we blame the consumers themselves for getting into debt when they knew they had no realistic chance of making their repayments? The answer perhaps is that everyone is to blame. A lack of education and understanding throughout our history could be the answer but then that poses the same finger blaming as to who should have been educating us. We probably should have all been educating ourselves. Greed is an inordinate desire to acquire or possess more than one deserves especially with respect to material wealth. Could the answer to all of this simply be 'Greed'? Maybe Gordon Gekko was on to something.