Between the Lines: Controlling credit is key to solving financial crisis

Published on Thursday 27 November 2008 20:31

SIR James Crosby's report to the Chancellor on how to get mortgage finance moving again is not light reading. But it was clearly essential reading for Alistair Darling as he announced this week that he intended to implement all the report's recommendations. Reading through it, I can see why. Without the actions Crosby recommended, mortgage loans may disappear, causing untellable economic damage.

The report underlines why the ability to borrow and lend is so important to the modern economy and why getting borrowing and lending moving again is hugely important.

But I worry that in rushing to apply some extremely expensive bandages to the broken mortgage finance markets, we might be in danger of repeating the same cycle of mistakes that has led to the current crisis. In essence, we are in trouble now because we buried ourselves under an avalanche of unredeemable debt and the report, while providing the tools for digging ourselves out, also seems to me to pave the way for doing it all over again.

How we got here is clearly laid out by Crosby. The traditional banking model for lending is that a bank takes in deposits from savers and then lends that money out to borrowers, taking a profit from the difference on the interest rates charged. That puts a limit on how much money can be borrowed.

But then clever financial types invented securitisation. A bank bundles some mortgage loans into a residential mortgage-backed security (RMBS), puts them into a subsidiary company called, variously a structured investment vehicle (SIV) or a conduit, which then sells the bundle to an investor.

The investor, which might be a pension fund manager or another bank, gets a stream of money from the mortgage interest payments (channelled through the bank's SIV so you don't notice that your mortgage payment is going to someone else), and the bank gets a pile of money, which it can use to lend more mortgages. Brilliant. It's a form of alchemy. Money being used to create more money. Banks were just thrilled by this so, as Crosby reports, between 2000 and 2007, the total amount outstanding in British RMBS rose from 13 billion to 257bn.

Then some even cleverer financial types had a bright thought. Why don't we just repeat the trick? So they took lots of RMBS and bundled them into a collateralised debt obligation (CDO) and sold them. Again, the buyer gets a stream of income and the even cleverer financial types get a pile of money to do more bundling and selling.

This was happening right across the financial spectrum. Everything from credit card debts to company debts was being alchemised into yet more money in this way. Crosby reports: "The outstanding value of interest rate swaps and other derivatives … reached 11 times that of annual global GDP by end-2007."

What? Note the word "derivative" in the above paragraph. A derivative has no intrinsic value. Its value derives from something else that does have an intrinsic value. But when that intrinsic value disappears, as happens during a recession, the huge bubble of derivatives built on it goes pop. And the current "value" of derivatives is 11 times the real intrinsic wealth of the world? No wonder we are in trouble.

As we now know, all these RMBS and CDOs have been sold and resold, while property values have sunk and the owners of mortgages have been defaulting on their payments. No-one yet knows whether these so-called securities are worth anything and as lots of them are owned by banks, the banks have become frightened to lend to each other and no bank has much money to lend in the shape of mortgages.

Crosby reckons that the inflow of deposits to banks on which they could restart traditional mortgage lending will be too small to be significant. So his solution, essentially, is that the RMBS market has to be restarted, by the Bank of England buying them from banks, giving them more money to lend.

But hang on. Isn't this where we got on to this crazed rollercoaster? What this securitisation business created was a great pile of credit looking for a home. And as we know, it was lent recklessly, in America more than here, to people who could not afford the repayments – subprime borrowers. And the great growing heap of credit chasing a relatively fixed number of prime borrowers caused inflation in property prices, which are now deflating because the heap of credit has been blown away in the winter winds of recession.

Nonetheless, Crosby is correct. Unless a certain amount of the new financial alchemy is used – he reckons about 100bn of RMBS will have to be bought over the next two years by the Bank – the housing market slide will turn into a collapse, and even greater economic trouble will follow.

Although he proposes a range of safeguards around this Bank activity, what's missing is the big picture backstop to prevent credit-fuelled asset inflation happening all over again. My own view is that we have to relearn the extremely painful lessons of the 1980s. We learned then that in order to control monetary inflation, we have to control the supply of money. And it worked – monetary inflation was brought under control.

Asset prices, however have inflated wildly. Now we have to control asset inflation to prevent the kind of asset price bubbles we have seen in house prices, stock market values and commodity prices. That means controlling the supply of credit. It will be hard, it will be painful. Free marketeers, and I am one of them, will object. But this particular free market has suffered a catastrophic failure and I cannot see any way of preventing it occurring again other than by controlling the supply of credit.

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