Credit Crunch: End Of The Beginning?

28/02/2014 at 6:07 pm

It is now seven years since the first signs of strain and balance sheet writedowns signalled trouble in the US subprime mortgage market. A few months later – in June 2007 – the first credit rating downgrades of securities backed by pools of these mortgages occurred. The collateralization and ownership restrictions placed on institutional investors in the vast “asset backed” market were superglued to these ratings. On the back of the downgrades, Bear Stearns put up $3.2bn of lending to prop up one of its two subprime hedge funds. Amid collateral calls the entire subprime mortgage market collapsed. In July Bear announced that both its funds were worthless, and for the next few months an explosion in downgrades (and underlying mortgage defaults) began to focus the financial world’s attention.

So it may seem surprising to say that we are only really at the end of the beginning of this crisis. Seven years is a long time. And yet …

Last week saw the release of Q4 mortgage delinquency data for the US. The headline number showed that delinquencies – loans at various stages of falling behind with payments up to and including foreclosure – as a proportion of the whole mortgage market fell again, to 6.4%, as they have done steadily since peaking at 10.1% in March 2010. But dig deeper and we find that the subprime delinquency rate ticked up. In fact it has been stuck in a 20-22% range for the last two calendar years, not far shy of its 27% peak in ’10. The overall improvement in delinquencies has been entirely due to improvements in the prime mortgage market over that period. Subprime foreclosures are running at over 10% of loans, still materially higher than at the peak of the previous default cycle in 2000. For that reason, there are still plenty of ratings downgrades on mortgage-backed securities working their way through the system.

At the same time it is right that the US mortgage market has lost its power to terrify. Overall, as we know, the real estate market has been picking up again (with a recent setback driven by the execrable weather). And bank balance sheets have improved steadily and considerably in line with the mortgage market overall. Reserves for losses on loans across the Big Four US banks – JP Morgan, Bank of America, Citigroup and Wells Fargo – peaked at $158.8bn in Q1 2010. The current reporting season showed that had fallen by almost 60% to $67.8bn in the quarter just gone. That’s some way north of the $42.2bn reported at the end of 2007, but still pretty impressive.

Perhaps this partly explains why it looks too cautious from a US perspective to say we are only at the end of the beginning of the credit crunch. From a more global perspective, however, the description fits more clearly.

Here in the UK our banks have not recovered so well. At Barclays, loan loss reserves only trickled slightly lower last year and are roughly 41% below their reported peak. For Lloyds the figure is 38% and at RBS of course reserves hit a new high of £25.2bn for Q4 – 39% higher than the amount provisioned for at the end of 2010.

Turning to Europe, where banks are at least as far adrift, we have another aspect of the crunch to contend with. In some cases (most notoriously perhaps in that of Iceland), bank distress led directly to a sovereign debt crisis. In most countries it played a significant role – as did the crunch’s recessionary effects on the wider economy, of course. And we should remember that the Cypriot banking system went down less than a year ago, all part of the same protracted drama of downgrade, writedown, bailout and default.

Symptoms of the sovereign crisis remain. The yield on ten year Greek government debt fell below 7% only today for instance, the first time since the country’s ignominious junking by S&P in April 2010.

Which brings us on to the next stage. Greek government debt to GDP for 2013 is forecast by the IMF to reach 175.7% – more than 5% above the peak reached prior to the debt restructuring of 2012. It is still not certain whether another restructuring of one kind or another will be needed to make this manageable on a 5-10 year view. Much will depend on how the economy performs this year. And it is still less certain when Greece will be able to consider re-entering the bond market, as some less severely crippled bailout economies have already done.

Once we know that the Greek debt position is settled it could be the beginning of the end of the credit crunch, and not before. Then Greece – as others, including the rest of the eurozone, UK and the US – will be set on the path of managing its economic affairs with a huge burden of borrowing round its neck that will mark fiscal planning with servicing costs for many years to come. That is the lasting legacy of the insane credit markets of the mid-2000s. Only when that borrowing, weighing down across most of the developed world, has been firmly established on a reducing path for some time – only then will we be able to say that the credit crunch is over.

In terms of what all this means for markets let me make one observation.

Risk markets became absurdly optimistic in a short period of time during the end of the Great Recession in 2009, not at all seeming to understand the scale or possible longevity of the problem. Then came the sovereign debt crisis and a period of complete panic in 2011, and then, pretty steadily since the most successful example of Open Mouth Operations in history (by the ECB in mid-2012), risk has come back into favour.

The key point is this: by backing fundamentals, and so being sceptical of risk in late 2009 and more constructive thereafter (and especially in the autumn of 2011), investors would have done pretty well.

The gargantuan upheaval of the credit crunch and the hysteria which followed have left their mark in different ways at different times. There are still plenty of anomalies out there both between and within asset classes. As and when (and if) the ripples from that giant explosion seven years ago continue to fade, there is every reason to continue to expect that backing the fundamentals will remain a profitable thing to do.


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