Wednesday 29 August 2007

Pic of the day: The property market has become somewhat... unbalanced, lately. (But I'm happy to say this picture is entirely fictional, from the slightly futuristic game City of Heroes.)

Bank-quake

Most of us don't have "subprime" loans, and a good thing it is too. Most of us probably think we haven't lent to any such either, but this is less certain. Especially if you have money in the bank, or even some pension funds. It is probably not a big part of your savings anyway, so it ought not to be a worry. The problem is, nobody seems to know for sure how big a part. Nobody knows exactly where those loans are now, because they were packaged along with other loans and sold, and then packaged and sold again, or used as collateral, or companies owned shared in other companies that had invested in those mixed bags… you are starting to see, I hope, that this will take some time to sort out. In fact, it may not be sorted out until the "sub" borrowers fail to pay, and the money fails to show up where it was expected. Wherever that may be.

So far, moderately good. I mean, since the rotten loans are scattered so widely, there is pretty much no chance that they should all end up in the same basket, namely your bank, right? We have nothing to fear except fear itself. Unfortunately, fear itself has reared its ugly head. In the middle of August, while many common workers were still on vacation and others were sleeping soundly at night, banks across the civilized world started to panic. On a normal day, there are a lot of transactions between any two banks in the same country, and many between large banks in different countries as well. You can't always expect these to make up the same amount: Often bank A transfers more to bank B which transfers more to bank C which transfers more to bank A again. Triangles, rectangles and pentagons are only the start of the complex web that money follows from bank to bank while we go about our daily lives. In the end it all goes around. Or that's how it used to be.

When one bank pays more than it gets in on any single day, it borrows the difference from the other banks involved. Usually this is no big deal, since the balance could tilt the other way tomorrow or next month. So there are overnight loans and there are 30-day loans, usually very cheap. After all, they are banks; they can borrow from each other. Today me, tomorrow you, no big deal… until the fear arrived. And the banks started to get nervous. Why is that bank trying to borrow more than it did last month? Could it be that they are sitting on a bomb of bad loans? What if they don't pay back? What would happen to us if they don't pay back, what would we do if our own customers came and asked for their money back? So the banks started to require higher interest rates from each other. Yes. In effect, the banks no longer trusted each other to stay afloat overnight, much less for a whole month. This was madness, everyone knew it, but nobody dared be the one taking the risk.

Luckily, central banks have routines for this. It is one of the things that rarely happen but that every central banker knows. You can wake a central banker at 3AM and shine a flashlight in his face and ask him: "What do you do if the banks start to panic?" and he will answer: "Increase the money supply, but not change the rates." That's what the Federal Reserve did, and the European Central Bank, and smaller banks in Europe and soon also in Asia. Large emergency loans were rolled out, so that every bank that needed cash to clear its day to day business could borrow as much as they wanted. The loans would have to be paid back quickly though, in a matter of days, so that nobody should be tempted to invest them in some other project than what they were meant for.

It worked. The common laborer hardly even heard about it. They slept soundly and had no idea that their savings bank had been hours from insolvency. (Actually I don't think common laborers even know what that means. Basically the banks might have been unable to pay the money they should. If that had happened, the laborers would definitely have heard about it. But that was not to happen for some weeks yet.)

The tremors continued for days on end, and the central banks had to keep the firehose open. The US Federal Reserve (usually called the Fed by economists) also offered huge amounts of somewhat longer credit, which four of the bigger banks accepted. Some say that they did this to show smaller banks that it was not a sign of weakness to accept cheap credit. Others say that it was a sign of weakness and that now is the time to panic. I'm firmly with the first group, seeing how Bank of America used some of the cash to bail out the struggling property credit company Countrywide. Still, it says something about the state of panic in the financial world, that even some of the largest banks in the world were thought to be in danger.

Actually, this is just the beginning. My long-time readers will have expected this, at least those who have an interest in economy. The big question is what happens next. International trends have put an upward pressure on prices, and normally interest rates ought to increase further. It is perfectly possible for the Fed (and other central banks) to raise interest rates while at the same time offering large loans. This is what I would have recommended, as would Alan Greenspan, the former chairman of the Fed. I don't think his successor Ben Bernanke is made of the same stern stuff, though. Most likely he will lower interest rates in an attempt to save the economic expansion. But this could backfire if it is seen as a sign of panic, which it may well be. The dollar is already sliding quickly, spreading the cost of the American problems all over the planet. If the rapids of the sliding dollar turn into a waterfall, the Fed could lose control of the currency. This is a certified Bad Thing.

Anyway, just this update for now. Things will continue to unfold as the "NINJA" borrowers (no income, no job or assets) fail to actually pay their bills, and the lenders have to consider whether to "foreclose" as they say over there… whether to throw out the current owner and sell the house. This is a risky business. Even if the owner does not trash the home before leaving (surprisingly common, especially among this kind of customer) it is unlikely that you will get back the value of the loan, and the borrower will no longer even attempt to pay anything. You have pulled the loan, he is out of it, and you have to write off the loss. If you just let it slide, you can still hope that something will happen to make the money arrive eventually.

No matter what, the housing credit bubble is over for this time. According to The Economist, it was the largest economic bubble in recorded history. The "unwinding" of it should prove to be very interesting. This is an awe-inspiring time for an economist to be alive. Kind of like being a military expert during a world war, I guess. So many theories will be put to the test. So few will survive. Theories, I mean. Or that's what I hope. After the 1929 bubble burst, we got the Great Depression, trade wars, Fascism and Nazism, and World War 2. But it need not go that way this time. Especially if the governments manage to sit very still and leave this to the highly trained professionals.