Subprime market crisis as explained to my 3 year-old niece

Other than what I am sure you have all heard, read and figured out already, here's my take on the matter. Basically, the recent crisis on the global financial markets has been in the making for a while now. Investor confidence created by the longest sustained period of global economic growth may ultimately have lead to the market shocks as has been experienced lately. What Allan Greenspan once termed "consumer exuberance" resulting from "irrational" confidence in the markets seems to have affected large scale investors?

With a good market performance forecast, from all manner of experts, investors "bought" into the credit market of major global lenders - both wholesale and retail banks (Credit Derivatives come to mind). These large scale investments, usually by Hedge and Mutual Funds, created a substantial amount of liquidity in the global economy (particularly the more advanced economies) affording banks to grow their loan books by offering more credit to the consumer. Naturally, with “excess” liquidity available to lend out, banks became all too willing to extend credit to less than stellar borrowers, albeit at a premium. Banks would thus "ease" their traditional prerequisites of a good credit history and stable financial circumstances for borrowers before credit could be extended. To mitigate the inherent risks of lending to these markets, banks would assign a premium rate that is higher than the prime lending rate (prime is the rate at which retail banks lend to the consumers “normally”) This practice, of adding a premium on prime to poorly credit-rate scoring borrowers, is what we have now come to know, rather infamously, as subprime lending? Of course, it is worth mentioning that this measure was in addition to the loans being secured by investors, as aforementioned.

There is a strong argument supporting the idea of making money available to a wider base through sub-prime lending. Some of the arguments for include consumer driven economic growth and an avenue for individuals to recover from short term financial crises. However, the opponents argue that the substantial amounts of liquidity available in the market as a result of sub-prime lending leads to inflation. The latter seem to have won over Central Banks around the world, particularly in the past 20 months. Central Banks have responded as naturally as a Central Bank would to the risk of inflation - raise the REPO rates. Simply put, REPO is the interest rate at which central banks lend money to retail banks. In South Africa, for example, The Governor of The Reserve Bank (SARB), Tito Mboweni, has argued that the double digit growth in property prices, record boom in sale of motor vehicles amongst others, is a result of "reckless lending practices" (in other words, subprime lending) that banks in South Africa have been exercising. The fear of the resulting inflationary pressures on the economy has led to a successive series of REPO rate increases and the enactment of specific laws to reduce "reckless lending practices" (i.e. subprime lending). The trend has been mirrored in both the US and UK where Central Banks have raised interest rates over, at least, 5 quarters.

The push for higher interest rates by Central Banks is designed to discourage excessive borrowing by consumers. However, and more significantly, the result has been that the people, who had obtained credit easily on a subprime market, cannot now afford to pay back their debts. In lay terms, more people are defaulting on credit card repayments, vehicle loan financing and mortgages (home loans), which in most economies constitutes the largest segment of consumer debt. The very risk that subprime lending was meant to mitigate is now materializing.

Remember, and as mentioned, the main reason that banks were offering these subprime credit facilities to consumers was because their loan books were "secured" by large scale investors (Mutual Funds, Hedge Funds et al). So when, since mid 2006 for that matter, the largest credit market (USA) began to show significant signs (in %) of defaults on mortgages, it became clear that the investors would lose money on the loan books they had secured from the banks. Put differently, the investors would have to cover the defaults in the market because the risk of the banks' loan books is on their books (an understanding of Credit Derivatives helps explain this)?

With the imminent losses in the credit market now clear and present, the obvious question that begs to be asked is, if the investors (Mutual Funds, Hedge Funds et al) are securing the banks loan books, who, in turn, is securing the investors investment on these loan books? In other words, who insures the insurer? Who holds the ultimate risk? So even though the signs of a “credit crunch” have been clear since mid 2006, what has not been clear is who, ultimately, is exposed to this risk. Basically, banks and investors alike have been caught up in a deadly embrace in determining the risk exposure in their books.

The panty dropper was when, last week, BNP Paribas announced it was suspending its hedge funds as it would not definitively ascertain who had ultimate custody of exposure on the securitised debts. Major players on the markets such as Goldman Sachs and other large hedge funds in the USA took similar actions.

This series of reactions necessarily means that large scale investors were no longer willing and/or able to "secure" the banks' loan books. As a consequence, banks become less “able” to extend new credit to the consumer. This has seriously restricted the availability of liquidity in the markets. To address these liquidity problems, The European Central Bank (ECB) and the Securities and Exchange Commission (SEC) have each injected hundreds of Billions of Dollars to provide this much needed liquidity in their respective markets.

So why is this affecting the market, you may ask? Well, a number of reasons really. One of them is that the complex world of large scale investment funds, Hedge Funds for example, means that some investors in these funds can pull out their investments with a short term notice. This necessarily means that the Hedge Fund has to have liquidity for when the investor calls on her investment. In order to obtain this liquidity, they have had to sell off other investments, including equity on the large stock exchanges like New York Stock Exchange (NYSE), London Stock Exchange (LSE), Johannesburg Stock Exchange (JSE) etc. This sell off has resulted in a depressed market. The two days, 14th and 15th August, particularly experienced heavy selling on the NYSE and LSE because the tenure of 45 days before an investor can call on their investment in an investment fund (these deals are way too complex to explain here, perhaps after I leave the Isle of Man and downed a few single malts?). So the selling in the last few days is to settle for September 30 / October 1. This is just one of the reasons, there are many more.

What about currencies? Well, some of the most leveraged investors in the US and emerging markets are Asian investors. Asian investors had borrowed the low yielding Yen to invest in higher yielding currencies like the British Pound Sterling, US Dollar, Aussie Dollar and even Rand. The selling off of Sterling, Dollar, Rand assets on the LSE, NYSE and JSE respectively has triggered a sell off of their investments in these currencies. It only makes sense because the value of their investments in these high yielding currencies was decreasing and thus their Yen borrowings would become more expensive. In the currency sell off, major currencies and currencies in some emerging markets have weakened as the yen has strengthened?

The ultimate fear is that all this may cause a global recession arising from a diminished confidence in the markets coupled with high interest rates. When this happens, investors resort to commodities such as Gold. Who knows, this could ultimately help shore up some African economies where commodities are mined? This again is not clearly understood and is influenced by exogenous factors beyond the understanding of this blog.

I hope this has been helpful! It's as much as I can provide on a lull mind! Ask me after about half a dozen Johnnie Walker doubles.

Ntheye Lungu.