THOUGHTS ON THE FINANCIAL CRISIS

IN JULY 2007, two hedge funds operated by the investment banking firm Bear Stearns declared bankruptcy. At that time very few people probably thought much of it: after all, investment vehicles lose money all the time, so why would this signify anything different? With hindsight, however, it turns out that July 2007 marked the end of the credit bubble that stood behind the real estate bubble in the United States. Once that bubble was pricked, the real estate bubble also popped. Once the real estate bubble popped, it turned out that much of the growth in the US and even the world economy had become addicted to the continued appreciation in US home prices. How could this be the case? Well, it turns out that these three bubbles – credit, home prices and US consumption – had all become self-reinforcing. The proximate cause for our current troubles was the Federal Reserve Board’s decision, following the collapse of the dotcom bubble and the attacks of 9/11, to attack what was a mild recession by radically lowering interest rates. Interest rates reached a level where they were negative in real terms , meaning that they were less than the inflation rate. In effect, the Federal Reserve was giving away money.

This money quickly flowed from commercial banks to US consumers in the form of easy access to all kinds of credit: home mortgage credit, home equity credit and what seemed to be a never-ending supply of consumer credit cards. The Federal Reserve’s easy money policy was intended to spur domestic spending, and was in fact extremely successful: from the third quarter of 2001 to the third quarter of 2008, consumer spending increased from $7.06 trillion to $10.19 trillion. This last number meant that consumer spending represented 70.6 percent of the US Gross Domestic Product. The increase in consumer spending also amounted to approximately 75 percent of the increase in the US GDP from $10.1 trillion as of the third quarter of 2001 to $14.4 trillion as of the third quarter of 2008. Interest rates continued to be low throughout the first decade of this century – even after the Federal Reserve began to increase short-term rates – because of the willingness of foreign investors, particularly countries such as China which enjoyed a large trade surplus with the United States, to invest those surpluses in US government bonds rather than, for example, increasing consumption in their own countries. (The Chinese, for example, save 40 percent of their net income, while Americans have, for the last few years at least, had a negative savings rate.)

Despite the substantial increase in con- sumer spending throughout this period, in- come of US households was flat. Americans could continue spending, despite the fact that their incomes were not increasing, because they felt they were richer: house prices were appreciating rapidly and so were Americans’ stock portfolios. In hindsight, much of this appreciation was attributable to the easy credit that stimulated demand, with the result that prospective purchasers overpaid for homes, and firms were able to generate excess profits driven by what appeared to be insatiable consumer demand.

Yet it was only when Wall Street got involved in the home mortgage market that what could have been viewed as only a real estate bubble metastasized into a threat to the entire financial system. From the perspective of Wall Street financiers, real estate was the ideal collateral: the risk of default was historically very low, and recovery rates were very high because there was little risk of deprecation in the real estate market. This led to the spread of mortgage-backed securities, bonds that were issued by entities that owned “pools” of home mortgages. Advances in computing technology allowed Wall Street financiers to devise ever more complex structures for these securities, with the result that more and more investors became involved in real estate finance. This in turn led to further availability of home mortgage credit, with the result that further impetus was given for housing prices to appreciate. Most importantly, however, mortgage backed securities, because they were often rated AAA by ratings agencies, attracted banks as investors. Because federal banking rules permitted banks to treat AAA-rated securities as the equivalent of cash holdings, banks could essentially loan out $9 for every $1 of AAA-rated mortgage backed securities they held. Because many banks purchased large quantities of these mortgage-backed securities, the health of the banking system became, to a significant extent, tied to the health of the real estate market.

Wall Street was not concerned, however, because based on historical models, the chances of a market-wide collapse in real estate prices was deemed too small to take into account. These models, however, did not take into account the nature of the new loans that were being made in the last years of the housing bubble. By 2006, if not earlier, all the traditional home purchasers were already in the market. The market could only grow if segments of the population that had been excluded from the lending market became eligible to borrow. Thus, the last and most deadly wave of “innovation” in home mortgage financing was introduced – the so-called “sub-prime” borrowers.

The only way many of these new borrowers could afford a mortgage was for the mortgage to be structured in a way that minimized their financial exposure in the early years, on the hope that the loan could be refinanced in the future at a time when the borrower either had increased income or the price of the home had appreciated. Accordingly, purchasers could obtain 100 percent loan-to-value mortgages, i.e., they were not required to put down anything as a down-payment; they could obtain floatingrate mortgages which would allow them to take advantage of the historically low interest rates of the period, but would crush them once interest rates began to appreciate; purchasers could obtain interest-only mortgages whereby their monthly payments were only interest and none went to pay down principal; and, there were even “negative” amortization mortgages, whereby the borrower would actually go further into debt for the first couple of years of his ownership. Such loans could only be made because investors were willing to purchase bonds secured by large numbers of such loans, the belief being that while such loans would be risky on their own, once aggregated into a pool, the risks of default would be minimized.

Unfortunately, this optimism proved to be unfounded. Once interest rates began moving up, many of these borrowers could not afford the increased monthly payments. To make matters worse, because interest rates were going up, housing prices peaked, and it was no longer an easy matter to sell one’s home.

Once it became clear that many of the sub-prime loans would default, banks recognized that they would lose money on their purchases of mortgage-backed securities. Because these securities were part of their capital, this meant that they would have to restrict the availability of loans. The inability of banks to make loans in turn exacerbated the decline of housing prices, as buyers could not come up with the funds necessary to purchase ahorne, thus necessitating further declines in home values.

But this led to further losses in the value of the mortgage-backed securities held by the banks, leading to further pressures to restrict credit. As a result, interest rates today on a 30-year mortgage are slightly more than 5 percent greater than the federal funds rate. For a 30-year jumbo mortgage, the spread is even greater: 6.33 percent. This indicates that banks are hoarding cash, something that does not augur well for a quick recovery in the US housing markets.

The ill effects of this credit crisis are not limited to housing, however. Because of the huge losses banks have suffered as a result of the housing bubble, they literally have no money to lend to anyone. In many cases, this means that firms which had not arranged for a line of credit prior to this cri- sis will not be able to obtain a new one, and for firms that have a line of credit, banks will only agree to renew it on strict conditions and at a substantially higher cost if they are willing to renew it all. Even that most funda- mental of credit instruments – the letter of credit – which is used to finance almost all international trade is now feeling the effects of the credit crisis as goods are piling up in international ports because exporters are unwilling to accept the letters of credit pro- vided by the importers as payment for the goods. Because each one of these crises is tied to the overall system of providing cred- it, only a systemic solution resolving the basic solvency of the credit system has any chance of bringing a halt to the negative economic spiral the world economy is now experiencing. And while US taxpayers are no doubt in shock over the $700 billion price tag for the US Treasury’s “Troubled Asset Repurchase Program”, it is unlikely that this represent all the funds that will ultimately be needed to stabilize the finan- cial system. The United States has been addicted to cheap credit for almost a decade and now that it is suddenly gone, it is unlike- ly that the consequences will be anything less than dramatic. No one should expect a quick recovery. It might take years before banks recover their losses and begin provid- ing credit again at a level that approaches what in a prior time had appeared to be “normal”. It will be years before the US consumer has paid off the substantial bills he incurred to finance his lifestyle. One only hopes that the least well-off members of the global economic system – the developing world – will be able to survive this global recession without the benefit of being able to export their goods to US consumers. In the long run, we will all be better off if they spent more of their wealth investing in the good of their own societies rather than subsidizing consumption of their products in developed markets.

Some Muslims mistakenly believe that if only the global financial system operated according to the model of Islamic finance, these problems could have been avoided. Sadly, I do not put much weight in such claims. Islamic finance is basically a kind of structured finance, just like the mortgagebacked securities that were at the heart of this crisis in the US. In fact, it is probably the case that many Islamic “bonds”, i.e. sukuk, will suffer losses as the real estate bubble in the Persian Gulf pops (unless various governments in the region intervene to protect investors, which they will probably do). Structured finance, by definition, is vulnerable to asset-bubbles because it explicitly provides credit based on the perceived value of the collateral. If collateral is overvalued because of a bubble, then too much credit will be provided against that collateral, whether in the conventional system or the Islamic one. This is not the time for fingerpointing, or worse, some kind of schadenfreude (glee at another’s misfortune). The entire world is threatened by this crisis, even those countries that never enjoyed the direct benefits on the upside of the US housing/credit/consumption bubble. Hopefully Muslim countries, along with all other countries of the world, can cooperate in fixing the global weaknesses that led to this crisis. While no one can know for sure what changes will be made in the global financial system, there can be little doubt that by the time of the next US presidential election in 2012, the global economic system will have undergone substantial changes, hopefully for the better.