Sorting out the 'credit crunch'

I am, as you may have noticed, an accountant, so I like to look at both sides of every equation - for example; for every reckless borrower there is a reckless lender; and for every overstretched buyer there is a vendor laughing his or her way to the bank. Similarly, the credit bubble was the cause and the effect of the property price boom; and the credit crunch is the cause and the effect of the property price crash. It's not just correlation; they are two sides of the same coin - you can't have one without the other.

MSM reporting of the whole credit crunch debacle - and the politicians' response thereto - has been muddled to say the least. I suspect because they haven't bothered to understand things properly, which are, if you follow the logic through, quite simple. But - be warned - like all simple things, it has to be explained and understood step-by-step.

The basic, fundamental, simple problem underlying all this Lehman Brothers/Northern Rock nastiness is that first-time-buyer households with an income of £30,000 have overstretched themselves with a mortgage of five-times-income to buy a home costing £150,000 at the peak of the market last year. Once the mortgage market returns to normal, the lending multiple will fall to three-times-income and property prices will fall by 40%, so in this example, the price of the first-time-buyer properties will fall to £90,000. (These are UK figures, but similar principles apply in the USA, Spain, ANZ or anywhere else that's had a credit/property price boom/bust).

In a simple world, without interbank lending, the building society lent an FTB £150,000 for a 100% mortgage in mid-2007 and credited the vendor with a deposit of £150,000. By the time house prices have fallen 40% from their peak, the poor FTB will be kicking himself, as he has overpaid by £60,000. Unless he wriggles out of that debt by declaring himself bankrupt, he will end up paying £977 a month until 2032 (assuming 6% interest, 25-year repayment mortgage), unlike a canny buyer who will wait until the bottom of the market in five years' time, use the money he has saved by renting not buying to pay a 20% deposit and pay £523 a month until 2032 (6% interest, 20-year repayment mortgage).

So last year's FTB has made a £60,000 notional capital loss, kicks self. His mortgage lender in turn, would be prudent to write down (more accurately, "make a general bad debt provision against...") the value of the mortgage advance on the basis that £60,000 of it is unsecured. Sure, that's not the sort of security that I'd want, but the chances of last year's FTB losing his job; falling behind on payments; being repossessed and declaring himself bankrupt is quite small. Even a rabid pessimist would look at a large sample of such mortgage advances and write off fifty percent of the unsecured portion, in our case, that would be £30,000 per FTB, or a write down of 20% of the initial advance.

Using my negative-equity-o-meter, a 40% fall from peak will see just under 3 million households in the UK in nequity. Let's assume average mortgage £150,000, average bad debt provision 20% = £30,000, £30,000 x 3 million = £90 billion (or about one-sixteenth of outstanding mortgages in the UK - which is three times my previous worst-case estimate and so probably wildly overstated).

So we are straight into the realms of double-counting - we have 3 million households kicking themselves that they overpaid by £60,000 (=£180 billion) and banks/building societies kicking themselves that they have to write off £90 billion of mortgage advances.

But it is the same loss! The losses do not add up to £270 billion; the losses are £180 billion. If - taking an extreme example - banks did the decent thing and sent recent FTBs credit notes for £30,000 each on the strict condition that borrowers kept up with repayments in future, that would still leave the banks' losses at £90 billion, but would halve FTB losses from £60,000 per property to £30,000 per property.

And it does not stop there.

The original mortgage lender packaged up those mortgages on overpriced properties to people who couldn't really afford them on a semi-recourse basis to an SIV in the Channel Islands. So the SIV is also booking a potential loss of £30,000 per mortgage.

And some investment bank invested in that SIV, so the investment bank is also booking a loss of £30,000 per mortgage.

And some highly leveraged hedge fund may have borrowed further to buy shares in that investment bank and enticed investors by promising annual returns of 10%. The hedge fund is booking a loss of £30,000 per mortgage.

And the original vendor may have withdrawn his £150,000 sales proceeds from the boring building society current account paying 5% interest and invested in the highly leveraged hedge fund. So that investor is worried about making a £30,000 loss as well.

So, we have the FTB worrying about a £60,000 loss and the building society, the SIV, the investment bank, the hedge fund and the hedge fund investor/original vendor all worrying about a £30,000 loss each. But the total potential losses on each mortgage do not add up to £60,000 plus 5 times £30,000 = £210,000!! The total loss per mortgage is probably in the order of £30,000 (if that) - this has to be split up between the various parties - if all six parties take a £5,000 actual loss on the chin, then they've all learned a valuable lesson and nobody gets wiped out.

Even better - and this parallels a previous post on the merits of Sovereign Wealth Funds - the ultimate source of all this easy credit and cheap finance is The People's Republic Of China and oil rich countries like Russia and the Middle East. So we in the West can pull a fast one, put our banks into receivership (in a controlled and orderly fashion) and tell the bond holders (the PRC and petro-states) "Oops, sorry! We can't repay the full value of those bonds, but hey, we'll issue you new bank shares to the face value of the shortfall." This would, from the banks' point of view convert a short term liability (bonds) into a long-term non-repayable liability (shareholders' capital), so our banks would be recapitalised on the sly without the need for these messy and embarrassing rights issues.

And if you don't like the sound of Johnny Foreigner running our banks, then just move your mortgage and your deposit account to a good old-fashioned British building society! Johnny Foreigner will end up owning bank buildings, thousands of computer terminals and bugger all else. A bank without customers is worth nothing!

Well, congrat's to anybody who's bothered to read this far. And double congrat's to anybody who understood it all.