The credit crunch – one year on

Written in August, one year after the beginning of the credit crunch, this article explains how that earthquake in the global financial system has left banks, insurers, pension and municipal funds, hedge funds and private equity companies tottering and falling. Collateral damage has been immense and the after-shocks are still to come.

As I write, it is one year since the great global credit crunch began. On 6 August 2007, America’s second-largest mortgage lender American Home Mortgage Investment Corp filed for bankruptcy. Three days later, France’s biggest bank, BNP-Paribas announced that it was freezing redemptions on three of its investment funds in sub-prime mortgages. Immediately, the European Central Bank announced it was injecting E75bn into the financial system. Only a few days later, the US Federal Reserve Bank announced a 50 base points cut in its funds rate and injected extra liquidity into the system. The credit crunch had begun!

One year on, this earthquake in the global financial system has left banks, insurers, pension and municipal funds, hedge funds and private equity companies tottering and falling. Collateral damage has been immense and the after-shocks are still to come.

How did it come about? Well, the trigger (but not the gun) was the collapse of the US housing market and the debacle of the so-called sub-prime mortgage market. As in many countries of the Anglo-Saxon world (the US, the UK, Australasia, Ireland, Scandinavia, the Baltic states) and even parts of Europe (Spain, Hungary etc), there had been a massive boom in house prices, particularly after the mild economic recession in the OECD of 2001. House prices had never risen so much and so fast.

Cheap credit from the banks and mortgage lenders enabled home owners to borrow hugely on the back of their house values. At one point, according to the great guru of American finance himself, Alan Greenspan, American home owners were taking $1trn each year out of the ‘value’ of the their homes to spend. This fuelled consumer spending and economic growth, as well as the stock market.

But it was all based on a lie. No real values were being created. Indeed, US and British householders were saving nothing. Household savings rates had dropped from 13% of disposable income in the 1990s to negative in 2005.

The credit-fuelled economy was a huge bubble waiting to burst. And so it did.

Eventually house prices got so high in the US that first-time buyers could no longer get on the ladder. They had been encouraged and cajoled to do so with sub-prime mortgages, in effect loans that required no deposits, no proof of income and no initial payments for the first six months etc. These loans were cynically sold to people (often on very low incomes in poor housing areas, mostly black and Hispanic) who very soon realized that they could not maintain the payments. Eventually, the housing bubble was pricked, beginning in 2006 and gathering pace to the collapse of summer 2007.

It was then that the banks and other financial institutions realized they were in trouble. They had made these loans and had then packaged them up as bonds or securities to be sold and sold again around the world to all sorts. The risk of default on the mortgages was thus spread around or ‘diversified’. In reality, it just meant that when the housing bubble burst, it affected not just mortgage lenders but all sorts of investors, big and small.

Take one. Irvine, California, was a planned community nestling between Los Angeles and San Diego. A year ago at this time, Irvine was home to 18 sub-prime lenders, including many of the leaders in the field, New Century Financial. Irvine had become the center of the sub-prime industry almost by accident. As the business of writing mortgages to riskier borrowers grew rapidly in the middle of the decade, many top employees at the established sub-prime firms struck out on their own, setting up shop nearby.

But the industry imploded even faster than it grew. New Century had become the second-largest sub-prime lender in the US. It filed for bankruptcy last April and essentially halted operations a month later. "Honestly, some people are still sitting here with their jaws dropping, saying 'How did it happen?' It was just so fast," said Jacquie Ellis, CEO of the Irvine Chamber of Commerce. "Typically when you have a downturn, it's a slow decline. That's not what happened here."

By the end of the year, almost 9,000 subprime jobs were gone from Orange County. Many of these people have been unable to find new jobs. And economic officials say that was only part of the economic pain. Suppliers and service firms from hotels and restaurants to printers and software developers that had come to depend on the lenders for a bulk of their business have had to cut staff as well.

Ellis said one hotel in town has lost $1m in annual bookings as a result of the subprime collapse. And small businesses, such as local trophy shops that produced the monthly sales awards, have been hurt. "Everybody was riding high, it was like fat city," said Ellis. "All of a sudden you look around and think, 'Joe across the street lost his job,' or 'Oh, my gosh, Sally next door lost their job.'"

The impact of this credit crunch was global. Narvik is a remote seaport where, along with three other Norwegian municipalities, it has lost about $64m in complex securities investments that went sour.

The residents want to know how their close-knit community of 18,000 could have mortgaged its future - built on the revenue from a hydroelectric plant on a nearby fjord - by dabbling in what many view as the black arts of investment bankers in distant places.

In 2004, Narvik and the three other towns took out a large loan, using future energy revenue as collateral. They invested the money, through Terra Securities, which offered a better return than traditional investments – namely US sub-prime mortgages. In June 2007, as the sub-prime problems were brewing, Narvik shifted some money into an even more complex investment, again through Terra Securities.

Within weeks, as the sub-prime market deteriorated, this investment declined in value and Narvik got a letter from Terra Securities, demanding an additional payment of $2.8m. The chief investigator of Norway's financial regulator, Eystein Kleven, said Terra Securities' Norwegian-language prospectus did not mention such payments, or other risk factors.

The towns are now engaged in legal action against the Norwegian brokerage firm, Terra Securities, that sold them these investments. They allege that they were duped by the firm's brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level.

Terra Group, which is in turn owned by 78 savings banks and remains in business, has rejected calls for it to compensate the towns. Norway's finance minister, Kristin Halvorsen, has ruled out a state bailout and Citigroup, which shut down one of the money-losing investments that Narvik bought, said it had no legal obligation.

The investments represented a quarter of Narvik's annual budget of $163m and covering the losses would necessitate taking out a long-term loan, which the town could only pay off by cutting back on services.

And it was not just the small town lenders and councils that took the hit. The great credit bubble burst eventually took down some of the giants of the global finance. In March, the US Federal Reserve was forced to rescue the fifth-largest investment house in Wall Street, Bear Stearns, when the securities firm faced bankruptcy and its failure could have led to a widespread financial collapse. As Ben Bernanke, the head of the Fed put it: “The adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability''.

The Fed agreed to give emergency funding to Bear Stearns after a run on the company wiped out its cash reserves in two days. During the weekend following the rescue, Fed officials helped arrange a takeover by JP Morgan at a fraction of Bear Stearns's market value.

All this was a far cry from the comments of Bernanke when the credit crunch first broke last summer. Then he said the bursting bubble would cost no more than $50bn and there would be just a few failures of some small regional banks invested in real estate.

As we review the collateral damage now, the current score of bank losses globally (and still counting) is $500bn, ten times Bernanke’s forecast. Moreover, up to 30 regional banks and mortgage lenders have gone bust in the US; and we know about Northern Rock in the UK (bailed out by £30bn of taxpayers money); as well as the ‘rogue trader’ scandal of $6bn in France’s Societe Generale – and we could go on.

Indeed, any reasonable estimate of the total financial damage globally puts the figure at over $1trn (the IMF) or even $2trn. That’s compared to world GDP of about $60trn, or 3% of world GDP. That is how much global growth is likely to lose over the next year. Given that global economic growth, including fast-growing India and China, is about 5%, that would take world growth below the 2.5% that the IMF reckons is needed to sustain employment and incomes on average in the world. And in the more advanced capitalist countries of the US, Europe and Japan, economic growth is likely to be below 1% or even negative in the next year.

Figures for the economy in the last few weeks suggest that now all of the G7 economies (the group of the major advanced economies including US, UK, Japan, Germany, France, Italy and Canada) are already in a recession or close to tipping into one. Other advanced economies or emerging markets (the rest of the Eurozone; New Zealand, Iceland, Estonia, Latvia and some South-East European economies) are also on the tip of a recessionary hard landing.

And once this group of 20-plus economies enters into a recession, there will be a sharp growth slowdown in the BRICs (Brazil, Russia, India and China) and other emerging market economies. For example, a country like China - that even with a growth rate of 10%-plus has officially thousands of riots and protests a year - needs to move 15m poor rural farmers to the modern urban industrial sector with higher wages every year just to maintain the legitimacy of its regime. So for China a growth rate of 6% would be equivalent to a recession. It now looks like that, by the end of this year or early 2009, the global economy will have that.

At the start of this article, I said that the housing collapse and the sub-prime mortgage debacle was the trigger for the credit crunch. But it was not the gun. The gun was the anarchic and crisis-ridden nature of the capitalist system of production. The bullet was declining profitability.

Capitalism, contrary to the views of the dumbest of capitalist apologists (usually the heads of government like George Bush or Gordon Brown; or the heads of the central banks and finance houses), does not grow in a straight line upwards. The very nature of production for private profit with companies, individuals and investors competing and gambling against each other leads to excessive and blind investment and expansion. The result is a massive waste of resources and damage to people’s lives.

Credit bubbles and subsequent crunches are not new. Indeed, they happen whenever the productive sectors of capitalism start to experience slowdown, namely profitability (the rate of profit) begins to fall. Then capitalists and financiers try to compensate by investing more into areas that are less productive, but provide better returns for a while (real estate, stock markets, fine art, gold etc).

What is different about this credit crunch is that it involved new ways of expanding credit beyond the productive capacity of capitalism. Traditional bank lending gave way to loans that were converted into weird and wonderful new forms of bonds and securities that were sold onto all and sundry as ‘safe and profitable’ investments. And bets and hedges called derivatives were also sold and bought on top of them. The global credit market (including loans, bonds and derivatives) expanded from three times world GDP to 12 times in just ten years.

So this credit bubble (the expansion of fictitious capital, as Marx called it) is different because it was huge and it was global. The impact will be the same: huge and global.

As the credit boom exploded, profitability of the productive sectors began to decline, particularly after 2005 (according to my figures). The credit bubble expanded even more in response. But just like a yo yo, credit growth reached its limit and has now jumped back with a vengeance.

The credit contraction is now experienced every day by people trying to get a mortgage for a house; borrow money to invest in new equipment or expand a business; or just to make ends meet. The banks won’t lend or if they do it is at exorbitant rates. With the banks squeezing credit, households must save, not spend and businesses must contract, not expand.

The credit crunch one year later means global economic recession one year (or more) onwards. That means housing repossessions, business bankruptcies, rising unemployment, falling real incomes and more loss of productive capacity. This is the bleak reality of the capitalist system of production.

Sure, now all the talk in the councils of government and high finance is that they have learnt the lessons of the crunch and they will ‘regulate’ and ‘monitor’ to ensure that it does not happen again. It won’t – in the same way. But as sure as the night is black, if capitalism continues as the system of the human organization, there will be more crunches and economic crises, even if the apologists' lies and excuses take a different form.

Indeed, I’ll finish with a prediction. This latest global economic recession will be one of the most severe; perhaps matching that of 1980-2. Eventually, global capitalism will recover, say from 2010 onwards. But this recession won’t be the last before 2020. There will be another, perhaps even worse, before the next decade is out.

Source: Socialist Appeal