Credit Crunch - From by sofiaie


									                                                              FRANS KONING



The financial crisis of 2007–2009 is often referred to as "the credit crunch" or "credit crisis".
In SA we only really started to feel it in late 2008. Now we know that it has something to do
with credit, something we have a lot of, sometimes more than we can afford, but earning a
good salary does not make you feel it that much, and if you do not earn a good salary yet
probably you have no property so it does not affect you that much either. So what
happened really?

There are always rumours of something happening bad somewhere, and it does actually,
but like all true South Africans you don’t take note of it until it touches your own pocket.
You do not worry about your neighbour being high-jacked, as long as it does not happen to
you. So nobody took note of the credit trouble brewing at the early stages.

I only started to take note of this when my coffee jumped from R36 per 200g to R52 per
200g, and when a litre of diesel cost me more than R12 per litre. How could this be
possible? How could things go so wrong so quickly? You hear how companies lose millions
of dollars and the JSE All Shares Index falls from 34,000 to 20,000 in a couple of months.

Many people fail to understand how a company could be worth R10 a share the one day and
the very next it is R6 a share. How can a butterfly clapping its wings in the US create a storm
in South Africa.

The idea of the presentation is to explain a little bit of this and make sense of what has been
happening in the markets worldwide to bring about this crunch that we feel on our budget

The first symptoms were seen in what is called the late 2000 recession, where a complex of
vicious circles that contributed to this crisis included high oil prices, high food prices and
with the main culprit - the collapse of the substantial $8 trillion US housing bubble, which
sparked an interrelated and ongoing financial crisis around the world.

The reasons proposed for this crisis are varied and complex and emerged over a number of
Causes proposed include

      the inability of homeowners to make their mortgage payments,

      due primarily to adjusted rate mortgages resetting

      borrowers overextending, predatory lending, speculation and overbuilding during
       the boom period

      risky mortgage products,

      high personal and corporate debt levels,

      financial products that distributed and perhaps concealed the risk of mortgage

      monetary policy, international trade imbalances, and government regulation (or the
       lack thereof).

In August 2002, Dean Baker (well known US economist) was the first to say that there was a
housing bubble in the US, basing his analysis on US-government house-price-data from
1953 to 1995. In his analysis, Baker wrote that from 1953 to 1995 house prices had simply
tracked inflation, but then when house prices from 1995 onwards were adjusted for
inflation they showed a marked increase over and above inflation-based increases.


Who says there is no such a thing as a free lunch? If you can purchase a property at some
rate below prime, based on some future income, and earn an immediate return on your
investment of more than prime, who would not invest at the maximum possible? Your main
risk is that of not being able to pay the instalments.

So what happened in the US? House prices were overvalued in the so called bubble. This is
fine as long as the mortgage owners keep on paying the monthly instalments. The problem
appears when

      mortgage holders start to default,

      Growth turns negative and the value owed is more than the property is worth,
       creating negative equity.

      The credit was already sold in a secondary market in the form of a financial security
       of which the risks were not appreciated.

Low interest rates and large inflows of foreign funds created easy credit conditions for a
number of years prior to the crisis. This fuelled a housing market boom and encouraged
debt-financed consumption.

The USA home ownership rate increased from 64% in 1994 (about where it had been since
1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this
increase in home ownership rates and in the overall demand for housing, which drove
prices higher.

Between 1997 and 2006, the price of the typical American house increased by 124%. During
the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1
times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.

Consider the South African situation: Assume a person earns R600 000 per annum,
translating to R50 000 per month. This person can afford a maximum of R15 000 per
month under the current credit regulations is SA, buying a house of about R1.2million.

This gives an implied ratio of about 2 for median home price to median household income
in SA.

Using the above ratio in the US the current homeowners would own houses worth roughly
R2.76million whether newly purchased or not. What this means, and it is similar in SA, is
that if you had to purchase your current house now, you would not be able to do it.

So while the demand is high the house prices increase but sooner or later it outperforms
salary increases so that nobody can afford it any longer and then the demand starts to
shrink, stabilising the situation or possibly bringing prices down again.

This housing bubble resulted in quite a few homeowners refinancing their homes at lower
interest rates, or financing consumer spending by taking out second mortgages secured by
the price appreciation. Everyone can now afford more debt.

USA household debt as a percentage of annual disposable personal income was 127% at the
end of 2007, versus 77% in 1990. While housing prices were increasing, consumers were
saving less and both borrowing and spending more. A culture of consumerism is a factor "in
an economy based on immediate gratification." Starting in 2005, American households have
spent more than 99.5% of their disposable personal income on consumption or interest

Household debt grew from $705 billion at year-end 1974, 60% of disposable personal
income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134%
of disposable personal income.

Alan Greenspan, Chairman of the Federal Reserve, has lowered the Federal funds rate to
only 1% for more than a year which, according to the Austrian School of economics, allowed
huge amounts of "easy" credit-based money to be injected into the financial system and
thus create an unsustainable economic boom, there is also the argument that Greenspan’s
actions in the years 2002–2004 were actually motivated by the need to take the U.S.
economy out of the early 2000s recession caused by the bursting of dot-com bubble —
although by doing so he did not help avert the crisis, but only postpone it.

The reduced interest rates sparked subprime mortgages and credit cards.
WIKI: “Subprime lending (near-prime, non-prime, or second chance lending) is a financial
term that was popularized by the media during the "credit crunch" of 2007 and involves
financial institutions lending to borrowers who do not meet prime underwriting guidelines.
Subprime borrowers are more likely not to pay the money back, such as those who have a
history of not paying loans back, those with a recorded bankruptcy, or those with limited
debt experience.”

The meaning of "subprime" changed during the last quarter of the 20th century. According
to the Oxford English Dictionary, in 1976 a subprime loan was one with a below-prime
interest rate; it wasn't until 1993 that the term took on its present meaning.

Both government action and inaction has contributed to the crisis. Increasing home
ownership was a goal of the Clinton and Bush administrations. There is evidence that the
Federal government leaned on the mortgage industry, including Fannie Mae and Freddie
Mac (the GSE), to lower lending standards. Also, the U.S. Department of Housing and Urban
Development's (HUD) mortgage policies fuelled the trend towards issuing risky loans.

The Federal National Mortgage Association (FNMA) commonly known as Fannie Mae, is a
stockholder-owned corporation chartered by Congress in 1968 as a government sponsored
enterprise (GSE), but founded in 1938 during the Great Depression. The corporation's
purpose is to purchase and securitize mortgages in order to ensure that funds are
consistently available to the institutions that lend money to home buyers.

Unlike other nations, the US Tax Code allows 100% tax deductibility of all interest payments
and part of principal payments on loans for housing. This means a tax break of 30% to 50%,
not only of the real interest but also of the inflation part of nominal interest rates. This tax
break is what fuelled second and third mortgages, used to buy cars and other consumer
goods. Interest rates on car purchases are not deductible, but second mortgages are. This
tax give away is what makes America become the most personally indebted nation in the

This credit and house price explosion led to a building boom and eventually to a surplus of
unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006.

Easy credit, and a belief that house prices would continue to appreciate, had encouraged
many subprime borrowers to obtain adjustable-rate mortgages (ARMs). These mortgages
attracted borrowers with a below market interest rate for some predetermined period,
followed by market interest rates for the remainder of the mortgage's term. Borrowers who
could not make the higher payments once the initial grace period ended would try to
refinance their mortgages.

Refinancing became more difficult, once house prices began to decline in many parts of the
USA. Borrowers who found themselves unable to escape higher monthly payments by
refinancing began to default.
As more borrowers stop paying their mortgage payments, foreclosures and the supply of
homes for sale increase. This places downward pressure on housing prices, which further
lowers homeowners' equity.

The decline in mortgage payments also reduces the value of mortgage-backed securities,
which erodes the net worth and financial health of banks. This vicious cycle is at the heart
of the crisis.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-
2006 peak.


   1. The value of USA subprime mortgages was estimated at $1.3 trillion as of Mar 2007
      of a total $20 trillion market

   2. Between 2004-2006 the share of subprime mortgages relative to total originations
      ranged from 18%-21%, versus less than 10% in 2001-2003 and during 2007
   3. In the third quarter of 2007, subprime adjustable rate mortgages ARMs making up
      only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures
      which began during that quarter.

   4. By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM)
      were either 90-days delinquent or the lender had begun foreclosure proceedings,
      roughly triple the rate of 2005.

   5. By January 2008, the delinquency rate had risen to 21%, by May 2008 it was 25%.

   6. During 2008, the typical USA household owned 13 credit cards

   7. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million
      properties, a 79% increase over 2006

   8. This increased to 2.3 million in 2008, an 81% increase vs. 2007

   9. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in
      foreclosure. Between August 2007 and October 2008, 936,439 USA residences
      completed foreclosure.

Increasing foreclosure rates increases the inventory of houses offered for sale. The number
of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the
inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest
value of this ratio since 1981. This is basically the supply : demand ratio.

Furthermore, nearly four million existing homes were for sale, of which almost 2.9 million
were vacant. This overhang of unsold homes lowered house prices. As prices declined, more
homeowners were at risk of default or foreclosure. House prices are expected to continue
declining until this inventory of unsold homes declines to normal levels.


The first part of the problem was of a regulatory sort. US Treasury Secretary Robert Rubin,
and SEC Chairman Arthur Levitt vehemently opposed any regulation of financial
instruments known as derivatives. It was also claimed that Greenspan actively sought to
undermine the office of the Commodity Futures Trading Commission, when the Commission
sought to initiate regulation of derivatives. Ultimately, it was the collapse of a specific kind
of derivative, the mortgage-backed security (MBS) that triggered the economic crises of

Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers
have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage
defaults and foreclosures has caused more than 100 subprime mortgage lenders to fail or
file for bankruptcy.

The failure of these companies has caused prices in the $6.5 trillion mortgage backed
securities market to collapse, threatening broader impacts on the U.S. housing market and
economy as a whole.

However, the crisis has had far-reaching consequences across the world. Tranches of sub-
prime debts were repackaged by banks and trading houses into attractive-looking
investment vehicles and securities that were snapped up by banks, traders and hedge funds
on the US, European and Asian markets.

Thus when the crisis hit the subprime mortgage industry, those who bought into the market
suddenly found their investments near-valueless - or impossible to accurately value. Being
unable to accurately assess the value of an asset leads to uncertainty, which is never healthy
in an investment climate.
Economist Nouriel Roubini wrote in January 2009 that subprime mortgage defaults
triggered the broader global credit crisis, but were just one symptom of multiple debt
bubble collapses: "This crisis is not merely the result of the U.S. housing bubble’s bursting or
the collapse of the United States’ subprime mortgage sector.

The credit excesses that created this disaster were global. There were many bubbles, and
they extended beyond housing in many countries to commercial real estate mortgages and
loans, to credit cards, auto loans, and student loans.

There were bubbles for the securitized products that converted these loans and mortgages
into complex, toxic, and destructive financial instruments. And there were still more bubbles
for local government borrowing, leveraged buyouts, hedge funds, commercial and industrial
loans, corporate bonds, commodities, and credit-default swaps..." It is the bursting of the
many bubbles that he believes are causing this crisis to spread globally and magnify its

 Securitization is a form of structured finance, involves the pooling of financial assets,
especially those for which there is no ready secondary market, such as mortgages, credit
card receivables, student loans. The pooled assets are transfered to a special purpose entity
(SPE or ISSUER) and serve as collateral for new financial assets issued by the entity. The
diagram above shows how there are many parties involved.

Securitization, combined with investor appetite for mortgage-backed securities (MBS), and
the high ratings formerly granted to MBSs by rating agencies, meant that mortgages with a
high risk of default could be sold easily to "warehousers," with the risk shifted from the
mortgage originator to investors. Securitization allows issuers to easily generate capital for
new loans.

The traditional mortgage model involved a bank originating a loan to the
borrower/homeowner and retaining the credit (default) risk. With the advent of
securitization, the traditional model has given way to the "originate to distribute" model, in
which the credit risk is transferred (distributed) to investors through MBS and CDOs.
Securitization created a secondary market for mortgages, and meant that those issuing
mortgages were no longer required to hold them to maturity.

Asset securitization began with the creation of private mortgage pools in the 1970s.
Securitization accelerated in the mid-1990s. The total amount of mortgage-backed
securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized
share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased
from 54% in 2001, to 75% in 2006.

Alan Greenspan has stated that the current global credit crisis cannot be blamed on
mortgages being issued to households with poor credit, but rather on the securitization of
such mortgages.

American homeowners, consumers, and corporations owed roughly $25 trillion during
2008. American banks retained about $8 trillion of that total directly as traditional mortgage

Bondholders and other traditional lenders provided another $7 trillion. The remaining $10
trillion came from the securitization markets. The securitization markets started to close
down in the US spring of 2007 and nearly shut-down in the fall of 2008. More than a third of
the private credit markets thus became unavailable as a source of funds.

In February 2009, Ben Bernanke stated that securitization
markets remained effectively shut, with the exception of
conforming mortgages, which could be sold to Fannie Mae and
Freddie Mac.
Ben Bernanke Chairman of the Board of Governors of the United States Federal Reserve.
Bernanke succeeded Alan Greenspan on February 1, 2006. He is ranked 4th most powerful
person in the world in an annual ranking by Newsweek.


Some believe that mortgage standards became lax because securitization gave rise to a
form of moral hazard, whereby each link in the mortgage chain made a profit while passing
any associated credit risk to the next link in the chain.

A more direct connection between securitization and the subprime crisis relates to a
fundamental fault in the way that underwriters, rating agencies and investors modeled the
correlation of risks among loans in securitization pools. Correlation modeling--determining
how the default risk of one loan in a pool is statistically related to the default risk for other
loans--was based on a
"Gaussian copula" technique developed by statistician David X. Li.

This technique, widely adopted as a means of evaluating the risk associated with
securitization transactions, used what turned out to be an overly simplistic approach to

Unfortunately, the flaws in this technique did not become apparent to market participants
until after many hundreds of billions of dollars of CDOs backed by subprime loans had been
rated and sold. By the time investors stopped buying subprime-backed securities--which
halted the ability of mortgage originators to extend subprime loans--the effects of the crisis
were already beginning to emerge.

According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the financial
system when formerly uncorrelated risks shift and become highly correlated. When that
happens, then insurance and diversification models fail. There are two striking aspects of
the current crisis and its origins. One is that systemic risk built steadily in the system. The
second is that this build-up went either unnoticed or was not acted upon.

That means that it was not perceived by the majority of participants until it was too late.
Financial innovation, intended to redistribute and reduce risk, appears mainly to have
hidden it from view. An important challenge going forward is to better understand these
dynamics as the analytical underpinning of an early warning system with respect to financial

MBS and CDO credit ratings were downgraded. Credit rating agencies were then under
scrutiny for having given investment-grade ratings to CDOs and MBSs based on subprime
mortgage loans.

These high ratings were believed justified because of risk reducing practices, including

      over-collateralization (pledging collateral in excess of debt issued),

      credit default insurance,

      and equity investors willing to bear the first losses.

However, there are also indications that some involved in rating subprime-related securities
knew at the time that the rating process was faulty. Emails exchanged between employees
of rating agencies, dated before credit markets deteriorated and put in the public domain by
USA Congressional investigators, suggest that some rating agency employees suspected that
lax standards for rating structured credit products would result in major problems. For
example, one 2006 internal Email from Standard & Poor's stated that "Rating agencies
continue to create and even bigger monster—the CDO market. Let's hope we are all wealthy
and retired by the time this house of cards falters."

High ratings encouraged investors to buy securities backed by subprime mortgages, helping
finance the housing boom. The reliance on agency ratings and the way ratings were used to
justify investments led many investors to treat securitized products — some based on
subprime mortgages — as equivalent to higher quality securities. This was exacerbated by
the SEC's removal of regulatory barriers and its reduction of disclosure requirements, all in
the wake of the Enron scandal.

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid
by investment banks and other firms that organize and sell structured securities to
investors. On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts
of interest between rating agencies and issuers of structured securities. On 3 December
2008, the SEC approved measures to strengthen oversight of credit rating agencies,
following a ten-month investigation that found "significant weaknesses in ratings practices,"
including conflicts of interest.

Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in
mortgage backed securities. Financial institutions felt they had to lower the value of their
MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of
new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades
lowered the stock prices of many financial firms.

In December 2008 economist Arnold Kling testified at congressional hearings on the
collapse of Freddie Mac and Fannie Mae. Kling said that a high-risk loan could be
“laundered” by Wall Street and return to the banking system as a highly rated security for
sale to investors, obscuring its true risks and avoiding capital reserve requirements.


On Default Correlation- A Copula Function Approach.pdf

In SA we are only feeling some of the secondary or indirect pressures and are not in the
same dangers as in the US and some other parts of the world, as seen on the first graph.
Mike Brown, CFO of Nedbank, said “it would take a long time to work through the debt cycle
gripping the global economy, but South African banks were "structurally sound".

"We have a structurally sound banking environment in South Africa, which not too many
places in the world can say right now," said Brown who added that high levels of
capitalisation and low levels of gearing were the predominantly positive features of South
African banks.

Nonetheless, he warned against complacency. "We're certainly not going to be immune to
what is happening in the global environment and we cannot afford to be complacent."

Let us not be over-confident in the ability of the South African consumer to recover soon.

The local property market, and general economy is taking strain, and it seems it will
continue for some time. We cannot escape the global influences.

We have some other crisis’s of our own like the water, cholera, and electricity shortages and
Shabir Shaik out of jail, but with our focus mostly on the soccer in 2010.

Lets hope we can all ride through the storm, and may those who have the guts to invest
now have the glory in the years to come.


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