24th June 2009
The Global Financial Crisis: what caused it?
Inevitably, in the years to come, much will be written about the causes of the current global financial crisis. What was first called a "sub-prime crisis", then later "financial turmoil", is now being called the "Global Financial Crisis". Dr Luci Ellis is the Head of Financial Stability Department at the Reserve Bank of Australia (RBA), and in a recent speech, she reviewed some of the causes, as well as the consequences and countermeasures.
Interestingly, she looked at the build-up of tensions that finally broke as this financial crisis. She noted that appetite for risk had been strong for some years; that risk was priced cheaply; and as a result, credit markets were booming and some measures of liquidity were rising. The RBA had identified the low price of risk as a potential source of vulnerability for the global financial system. One sector that took particular advantage of low long-term interest rates was the US mortgage market. American households traditionally took out fixed-rate mortgages, often guaranteed by the government sponsored enterprises Fannie Mae and Freddie Mac - the GSEs. As rates fell, households re-financed in large numbers, but this extra origination business dried up once rates started to rise again. Rather than shrink their business, US mortgage lenders pursued riskier segments of the market that the GSEs did not insure. This included not only the sub-prime segment, but also so-called "Alt-A" and other non-standard loans involving easier lending terms. At the time, this was considered a positive development, because it was thought that it allowed more people to become home owners. Products requiring low or no deposit, or with low introductory interest rates were know as "affordability products". They allowed households to pay the very high housing prices that their own strong demand was generating (a very circular proposition).
As the US housing market boom wore on, lending standards eased further. Up until 2006, the sub-prime market segment increasingly allowed mortgages with very high loan-to-valuation ratios: that is, borrowers did not need much of a deposit. Low-doc loans became more common across the board. Negative amortisation loans, sometimes called "Pay-option" loans became more common. These are mortgages where the borrower can pick a repayment level that is so low that the loan balance actually rises for a while - something that is essentially unheard of in other countries.
The result of all that mortgage borrowing was an increase in leverage, defined to be the ratio of home mortgage debt to the value of the housing stock. This measure had been quite stable in the United States for a number of years. But it increased in those last couple of years of the boom, reaching around 45% by the time prices peaked in 2006. In Australia, the equivalent ratio is below 30%. Since many home owners own their own homes outright, the US figure implies that many Americans had very little equity in their homes by the time the boom peaked. And, of course, this measure of leverage has increased a great deal since US house prices started to fall.
click graph below for larger view
But you can't borrow your way to a good time forever, and this recent example of a credit-fuelled boom was no exception. The first signs of trouble were in the US mortgage market. Lending standards had eased so far - and outright fraud had become such a problem - that arrears started to rise more than lenders and investors expected. The extraordinary thing was that, unlike in every other housing burst, arrears rates increased significantly before the labour market started to weaken - and are likely to increase substantially as unemployment rises.
click graph below for larger view
It seems reasonable to assert that the sub-prime crisis was indeed the initial cause of the Global Financial Crisis. But like the recent Victorian bushfires, the financial and economic environment was such that after the first match was struck, the fire took hold with devastating consequences.
In future editions of Investment News we will look at some of the other causes, consequences and countermeasures as discussed by Dr Ellis in her speech. A full copy of her speech can be obtained here.
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Head of Funds Management
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Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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