I am going to try to explain what created the "credit crunch" (a slang for a general economic condition in which loans are harder to obtain).
CHAPTER 1: SUBPRIME LENDING
Subprime lending is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. Usually, these borrowers have to pay a higher interest rates on their loans as the default rate (chance of not getting the money back) is higher.
Lenders usually take into account the two scenarios: getting more interest of the same amount loaned versus have a higher risk of losing the money loaned. This creates an equilibrium.
CHAPTER 2: CDOs
Collateralized debt obligations (CDOs) was a financial product been in the market since late 1980s. Essentially, they consist in an heterogenous mixture of debt (loans, mortgages, bonds...) put as a pot, this product is structured in layers (called tranches): senior, mezzanine and equity. The structure of the product works as the folowing, the first to get the hit of a default is the equity, second the mezzanine and third the senior.
Example: An investment of 3 bonds with each valued at €100 with a third in each tranche.
A) Value of the bonds (portfolio) if none default = €300
Senior = €100 Mezzanine = €100 Equity = €100
B) Value of the bonds (portfolio) if one bond defaults = €200
Senior = €100 Mezzanine = €100
C) Value of the bonds (portfolio) if two bond default = €100
Senior = €100
D) Value of the bonds (portfolio) if the three bond default = €0
Nobody gets nothing.
As you can imagine, if you investment in the senior tranche you will receive less interest than in the equity, less risk less money.
Getting the interest for each of the tranches is not an easy job as depending on the assets and relationship among them you get more or less risky senior, mezzanine and equity tranches. The growth of CDO's was due to the development of the Gaussian copula models which allowed to define the interest to each tranche (known as pricing).
The models to price are created by the underwriter (an investment bank) and are reviewed by an independent (a credit rating agency).
CHAPTER 3: Banks start using CDOs
Well, here banks start to think, mmm... we can use these products to get rid of our risk in the subprime lending. We give the money to the borrower, he is our happy client, we take his loan/mortgage and we put in a CDO among other debt instruments, we sell the CDO, we get the money and if the borrower defaults, well is no longer our debt somebody else will take the blow.
This creates what is called a bubble. People were having easy access to the money to buy a house, they were buying the houses, houses were increasing prices, people were seeing prices go up, people were believing it was a good investment opportunity, people wanted to buy more houses, people were requesting more money... so forth and soon.
But well... if the banks are not running with the risk... who is?
Two agents: hedge funds & pension funds.
CHAPTER 4: Uncertainty about the investments in CDOs
Something was going wrong around 2006. The Fed was raising the interest rates what means an increase in the payments for those people with mortgages. As people was having difficulties to pay their mortgage more houses were given to the market in order to sale. Real Estate prices were starting to decline.
This is usually the end of bubbles, economic conditions change so borrowers can´t meet their financial commitments and lenders have to take the asset (house) but as the price has drop they can recover their investment.
However, the value of the CDOs did not change significantly. One would assume that if the subprime mortages were losing value, the CDO should be also losing value, that is true... but the value of the CDO is determined by a model we have seen in Chapter 2. What happens if you input the new subprime mortgages into the model and the output is a similar price as before? The model is working or is it wrong? The longer it takes the more belief grew that the models were not accurate.
That was like a russian roulette... you are hearing the clink, clink... and there will be a bang, but until the bang let´s be quiet.
CHAPTER 5: Clink, clink... baaaaaaaaang!!!
Minor companies were having problems, but at least big names were not affected. Just a few black sheeps in the big herd.
On June 22, 2007, Bear Stearns, the fifth-largest U.S. securities firm, found the bullet.
Two of his funds, the Bear Stearns High-Grade Structured Credit Fund & the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had troubles.
On July 18, 2007, Bearn Stearing said that its two failed hedge funds had little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages
The message was that it was an isolated case, but within the market everybody knew it won´t be the last one. More minor players were falling and uncertainy grew as Bearn Stearns could not recover as much money as expected from selling his CDOs (some CDO when they reach a certain value must be decommisioned by contract, so the bank had to sell the assets to the markets, the money they got was a lot less of what the models was saying it was worth > conclusion: models were not accurate).
On August 8, 2007, BNP Paribas decided to freeze three of their funds as the valuation was not appropiate. Also, there were rumours that Goldman Sachs was having troubles with some funds.
CHAPTER 6: The "credit crunch"
Imagine the situation, you are bank and you are lending money to other banks, funds, etc. You are hearing about these problems, some players are defaulting... are you going to give money as easily as before? Or you will start looking for more guarantess and receive more interest for the money you are lending to others?
Yes, so everybody took the same option, let´s think it twice, let´s ask for more guarantees and let´s ask for more interest. Nobody was giving money, and as a result the interest rates were rocketing.
You can draw a picture like the below one obtaining the historic rates for Euribor or any other interest rate.
The Central Banks (more or less the government) decided to intervene. If nobody is lending money that will an armageddon, somebody has to put the oil in the market or otherwise the machinery will grip and the whole financial system will collapse.
So the Central Banks started lending money in behalf of the old lenders. You can see big movements in the short term interest rate, these are central banks interventions giving money to the market and lowering interest rates.
On another scenario, more and more CDOs were dissolving and selling their mortgages into the markets. Prices were going down. What was the reaction of the market? We don´t want to hear about buying any product with mortgages inside. A market with lots of sellers and no buyers. Looks great?
CHAPTER 7: Northern Rock fall
The Central Banks were lending money to the markets... well except the Bank of England. The governor of the Bank of England, ervyn King, took a brave approach, those who are suffering now from the crisis are those who run into riskier businesses and must pay the price of being riskier.
Otherwise next time if being riskier does not have a price everybody will play the russian roulette again.
One on those was Northern Rock. The business model was the following:
A) We lend money to our customers to buy their houses.
B) We pack those mortgages and put a nice ribbon on the top.
C) We sell the packet to the market and get money.
D) With the money we do again step (A)
But now, the scenario was different, markets were not willing to buy these mortgages packets. The bank had to go to the market to ask for more money and more to keep the engine running, and then, interest rates start rocketing and it was more and more expensive to get that extra money.
On 13 September 2007, Northern Rock asked the Bank of England for help, it needed extra money for attending its demands. It was not a problem of not having the assets to cover its liabilities, it needed money to cover its short-term payments.
Next day, queues of people were asking for their money in the Northern Rock branches. The bank could be healthy, but if you stay at home and all the customers go and take their money at some point the bank runs out of cash (it invests your money in loans, mortgages, bonds... it does not have your cash in the coffers, banks make money investing your money) and then you lose your money. This is called bank run or run on the bank. Northern Rock had to ask for money, in the meantime their reputation and shares plummeted.
