Introduction
A credit crunch is the term economists use to describe a financial environment where investment capital is in short supply. It is a recessionary period in a debt-based monetary system where growth in debt money has slowed which subsequently leads to a drying-up of liquidity in an economy.1 A credit crunch is also known as a ‘liquidity crisis’ or a ‘credit squeeze’, where the banks will not or cannot lend and where investors cannot or will not buy debt. When it suddenly becomes very difficult to borrow money, this can have serious implications for an economy, both for private individuals and business. A credit crunch is often caused by poor and reckless lending, which results in losses for lending institutions and investors in that debt.
Global economic growth has been driven by access to cheap money; the ability to borrow at low rates. Recently the cost of borrowing, for both individuals and banks, has risen as institutions have become wary of lending money; at the same time banks are trying to conserve liquidity which has forced up borrowing costs. Problems in the global economy started when homeowners in the US, in the subprime market, began to default on their mortgages as repayments increased. This provided the trigger for the credit crunch which today threatens the macroeconomy.
Subprime is technically the name given to a loan to a borrower who has a low credit score: that is, a bad credit history. The interest rate for these loans is typically 2 to 5 per cent higher than for a prime loan.
The other sort of lending which has had an effect on the credit squeeze is ‘Alt A’ mortgage lending. ‘Alt A’ loans, also known as ‘liar loans’ require no documentation form the borrower who can self-certify their income. This type of lending was more limited in extent and the typical loans were provided to real estate speculators.
These mortgage loans, including subprime and ‘Alt A’ content, were then re-packaged in collateralised mortgage obligations. These collateralised obligations are like bonds and they are secured by the underlying properties and backed by payments on the underlying loans. These collateralised mortgage or debt obligations (CDOs) were then rated by the rating agencies and sold to other institutional investors. The original mortgage lenders retained no liability in respect of the loans and the sale of the collateralised obligations provided the liquidity to fund further loans. Inevitably, the original lenders appear to have relaxed their underwriting criteria, the number of such loans went up from about $200 billion in 2000 to $600 billion in 2006. This represents an increase from 8% to 25% of all mortgage loans. 2
Not all subprime loans were actually sold to subprime borrowers. In fact, it has been calculated that some 61% of subprime lending would have qualified for prime loans. There is therefore a potential exposure on the part of mortgage brokers to claims for misselling.
The mortgage loans were themselves divided into a number of categories: traditional interest and principal repayment; interest only loans: where interest only is repayable for the first 3 to 5 years of the loan; Adjustable Rate Mortgages (‘ARMs’); Option ARMs: where the borrower has an option on how much interest and principal he wants to repay at any time and if less than the normal interest payment is made then it is added to the principal amount of the loan leading to what is colloquially known as ‘negative amortization’ in the US.
In 2005, the adjustable loans represented about 51% of total lending. 70% of the adjustable rates were adjusted in 2007 and 78% will be adjusted in 20083. These adjustments have resulted in a payment shock for investors after the initial ‘teaser periods’. Some borrowers have found it impossible to re-finance as underwriting guidelines have been tightened or the value of property has declined.
Another problem for the lenders, apart from non-payment of loans, is that when mortgage debts were collateralized, it seems that the security of the underlying properties was not properly transferred at the same time. This fact came to light during the recent decision against Deutsche Bank in Ohio, when the Bank tried as trustee of collateralised mortgage obligations to recover debts from borrowers by enforcing charges over their properties. The borrowers put them to proof that the mortgage loans had been properly transferred. All that Deutsche Bank was able to show was a document showing intent to convey the rights in the mortgages, not the transfer itself, and Deutsche Bank lost its case. 4
Investors have turned increasingly against CDO’s. Where it has not been possible for investors to divest themselves of these instruments, CDO issuers (subprime lenders) have faced increased re-purchase demands from banks and investors. This has meant that liquidity in the sub-prime market has dried up. Some 80 subprime lenders have now gone into liquidation.5
Therefore, the credit crisis, which started with cheap mortgages for house buyers during a period of fast growth in the US, has blown up into what is arguably the most disruptive event for global finance since the Oil Crisis in the 1970’s. The credit market turmoil of 2007 has seen banks register write-downs and losses totalling more than $50 billion and according to experts there is no sign of let up. 6In the UK, consumer and business confidence has been shattered by the failed government rescue of Northern Rock and the knock-on effect that it is having on other lending institutions, with record numbers of people being refused credit.
Key market players affected by the Credit Crunch
- Mortgage Lenders
- Issuers of Collateralised Debt Obligations
The risk of lending to less-than-creditworthy individuals has been spread throughout the financial system through the use of CDOs. This has been achieved by parceling out and combining mortgage loans with other less risky loans by a process known as ‘slicing and dicing’. These complex financial instruments were then sold to banks, and through them, to private and institutional investors. The idea was that by spreading the risk, the financial system would be stronger. But instead, what has happened is that the toxicity associated with subprime has impacted even more widely across a globalised financial world.
- Credit Rating Agencies
Financial markets have traditionally relied on credit rating agencies, such as Moody’s and Standard & Poor’s, to make sure that the bonds they lend to are a safe bet. The rating agencies evaluate each bond or debt instrument and give it a letter rating, with ‘AAA’, the best. Investors such as pension funds use the ratings to ensure that they are only putting their money into safe, ‘investment-grade’ bonds. But now the credit rating agencies are under fire from regulators and politicians for being too slow to spot the dangers of subprime mortgage debts. According to the regulators, they are too close to the lenders, who pay them for the ratings.
- Investment Banks
Investment banks such as Goldman Sachs, Bear Stearns and Morgan Stanley, aim to make money by trading in financial products. They have been leading investors in private equity funds and hedge funds, and have also benefited by charging large fees for arranging mergers and takeovers. They have also played a key role in developing the specialised investment vehicles which parceled out mortgage debts to other banks and financial institutions. But now they are facing a sharp fall in income from these activities, and big losses on some of their investment funds that are linked to risky lending.
- Central Banks
The world’s central banks, such as the Bank of England, the US Federal Reserve and the European Central Bank see their role as setting interest rates in a way that controls inflation and ensures steady growth for their economies. But each bank is also the lender of last resort to the banking system and would be likely to intervene to bail out a large bank if they believed that its collapse would cause a more general financial panic. During this current crisis, the central banks have pumped billions of dollars into overnight lending to banks in order to prevent the banking system from seizing up, and to ensure that all the major banks can secure enough funds to continue trading.
Consequences of the Credit Crunch on Bond Insurers
Over the past few months all financial institutions have encountered problems; in the past few weeks the latest group to be affected are the bond insurers. Bond insurance companies such as Ambac, MBIA, and ACA Capital are facing a severe test.
This group of companies, also called ‘monoliners’, insures bonds that have been issued by other entities. The sector was created several decades ago in the US to insure bonds issued by US municipalities. Even today the US is the main focus and the largest companies, such as MBIA or Ambac, are American-owned. However, at the end of the 1990s the ‘monoliners’ moved into London, and now the UK is their second largest global market. Ambac, the largest UK operator, guaranteed $5.3 billion worth of UK bonds in the first nine months of 2007 alone.7
The biggest single reason for this exhilarating growth was the expansion of the private finance initiative (‘PFI’). When PFI projects started issuing bonds to finance themselves 10 years ago, some investors were cautious because it was hard to evaluate their long-term risks. However, the PFI companies realised that if they ‘wrapped’ the bonds with a monoline guarantee in a manner that ensured these instruments carried the top-notch AAA credit rating, investors would be more willing to buy the debt. According to Standard & Poor’s, 700 projects with a combined capital value of £50 billion have come to market since 1992. Companies such as Ambac and MBIA have wrapped almost all the existing PFI bonds, and issuers ranging from the BBC to Arsenal Football Club have also recently started wrapping bonds.
However, the problem now is that some investors fear monoline insurance companies face losses on subprime business. That could potentially hurt their credit ratings, which could, in turn, affect the value of wrapped bonds. The Fitch Ratings has warned of a ‘high probability’ that insurers CIFG Guaranty and Financial Guaranty Insurance Company will be placed on negative watch in coming weeks as a result of losses on subprime mortgages. Ambac faces a ‘moderate probability’ of slipping below the minimum capital cushion for the coveted AAA rating. The potential damage from any downgrade could stretch far beyond the companies themselves by lowering the credit ratings of the AAA bonds that they insure. This could force pension funds, mutual funds, and institutions to liquidate holdings on a vast scale, causing the credit crisis to spread into areas that have remained untouched until now.8
If re-rating does take place, it could impact on their reinsurance coverage, as questions may be raised as to when the direct insurers were aware of circumstances that could give rise to their re-rating, and whether such information should have been disclosed to reinsurers prior to any inception of cover or renewal.
The credit crunch is having an impact on the shares of Ambac, the world’s biggest bond insurer. Ambac’s shares have plunged by 65 per cent in four weeks. MBIA also saw its stock fall 51 per cent since October 5. 9
Implications of the Credit Crisis on Investment Banks
Banks may face up to $300 billion of losses from the subprime credit crisis over the next 18 months. So far, the top US and European banks have declared losses on subprime related debt totalling $52 billion.10 Further as the UK’s major banks approach their financial year-ends their share prices have collapsed on fears that they will follow their US counterparts with massive write-offs. In the US, by far the biggest write-offs have all come from the large investment banks. These investment banks were the specialists at the centre of the complex market which built up in CDOs for asset-backed securities.
Merrill Lynch
announced the largest third quarter write down at $8.4 billion, which cost its chief executive Stan O’Neal his job with a reported golden farewell worth $161 million. That was topped by Citigroup which, having announced a third-quarter write down of $6.5 billion, upped its estimate last weekend to as much as $11 billion. Recently Morgan Stanley said it will take a $3.7 billion write down in its fourth quarter but warned that this could rise to $6 billion if all its subprime assets turn bad.11The problem is that the credit crisis is far from over. Banks and investors in banks have no way of knowing just how much some of their most risky assets types will fall in value. UK bank shares have tanked since the credit crisis really began to hit in August. But the actual collateral damage to most UK High Street Banks from the subprime crisis could turn out to be much less than feared12.
Potential Litigation arising out of the Credit Crunch
Law firms in the UK are gearing themselves for an unprecedented rush forward in litigation between banking giants as a result of the credit crunch, in what looks like the biggest challenge to client relationships to hit the UK’s commercial legal industry in years. Partners across the City are anticipating a rise in major disputes, which have the potential to jeopardise numerous close relationships between the UK’s biggest firms and the banks; law firms have traditionally been reluctant to litigate against banking clients.
According to leading lawyers, banks are urgently taking legal advice ahead of a possible wave of litigation from investors facing losses arising from the credit squeeze. Leading banking lawyers claim a steady flow of queries about contractual obligations, with parties more tightly focused on the small print of deals. The banks are approaching lawyers more frequently to ask ‘how robust the structures are, what their rights are, and where there may be vulnerability’.13
Lawyers say that many queries have centred on commitment letters, with financial institutions asking whether they are obliged to provide the monies promised. Others have focused on areas of the notion of flexibility built into deals and the extent to which arrangers are entitled to ‘stretch’ the terms.
Most of the queries are for now being used to develop negotiating positions or perhaps stall lending commitments rather than to pursue full-blown litigation. However, several post-credit squeeze lawsuits have already been filed in the US, suggesting similar action will follow in the UK. Marsh, the world’s leading insurance broker and risk adviser, is warning the European financial services sector, including insurance companies, hedge funds, banks and ratings agencies, that they may be exposed to greater directors’ and officers’ liability (‘D&O’) and errors and omissions (‘E&O’) liability claims in the wake of the current subprime mortgage crisis.14 The potential litigation arising out of D&O and E&O liability could include: lenders’ lawsuits versus banks; shareholders’ lawsuits versus lenders, accountants, trustees and underwriters; insurers’ lawsuits versus lenders; investors’ lawsuits versus trustees; trustees’ lawsuits versus lenders and underwriters on behalf of investors; as well as individual investor lawsuits. 15
Lawsuits alleging misselling and misrepresentation are thought very likely by lawyers, particularly if borrowers try to argue that banks failed to disclose the full degree of risk. Courts would then have to decide whether experienced market users bringing these kinds of actions were as unaware of the dangers as they claimed.
Recently, Citigroup and Merrill Lynch have been hit with a flurry of lawsuits. Lawsuits have been filed by Citigroup employees for alleged violations of ERISA in connection with the loss of value in the Citigroup stock held in the plans. Citigroup shareholders filed a shareholders’ derivative lawsuit against the Company and former directors and officers. A firm filed a complaint against Merrill Lynch on behalf of shareholders who purchased Merrill Lynch stock between February 26, 2007 and October 23, 2007. The subprime crisis has generated an impressive quantity of high-stakes litigation. In the US 20 companies have now been sued in subprime-related securities class action lawsuits, in addition to the four residential construction companies and two credit rating agencies that have been sued in securities lawsuits. At this point, it appears very likely that there is significant additional litigation yet to come. The subprime mess may not yet have created any massive corporate failures on the scale of corporate scandals from earlier in this decade, but the event clearly already represents its own distinct and growing category of corporate scandal and related litigation16.
According to Guy Carpenter, the reinsurance broker, the cost to insurers of claims brought against directors of companies caught up in the US subprime mortgage crisis could comfortably exceed $2 billion. These would be losses incurred on D&O policies, which protect a director or officer of a company from paying out from their own pocket in a case arising from their duties as a director of a corporation.
The estimate comes in the midst of growing fears about insurance and reinsurance claims arising from the subprime mortgage crisis, following the recent write-downs announced by investment banks in the last few weeks and a broadening of the impact of the subprime debacle.17.
Another possible area of litigation includes disputes over complex deals in which companies have tried to cover potential losses on one investment by insuring with another. Such disputes were coming to court even before the credit squeeze, in cases such as the lawsuit involving an investment by Nomura in bonds in Railtrack, the rail infrastructure company. Nomura argued successfully that its rival bank CSFB, with whom it had hedged its exposure to Railtrack, had to pay out once the company went into administration.
However since law firms in UK are reluctant to sue the banks, investors who decide to press ahead with litigation in London face the task of finding a lawyer who will be prepared to risk antagonizing their clients and jeopardizing relationships with the banking industry. A survey by Legal Week magazine suggests that many lawyers think it is against the public interest for large firms to shy away from fighting top financial institutions in the courts.18 It will be interesting to see if this opinion prevails.
Conclusion
The far-reaching consequences of this credit crunch have renewed fears that global financial systems are facing their biggest crisis in recent years.
The slowly unfolding picture of who is affected, and to what extent, is likely to continue throughout 2008. UBS have continued the trend by just announcing a further $10 billion in losses. It is like watching a car crash in slow motion. It remains to be seen how effective the recent Bush administration initiative to assist certain subprime borrowers will be and whether it will prevent the credit crunch from extending into the wider economy. Whatever happens now though, like a motorway pile-up, once the flow has stopped, it may take a long time for the traffic to get going again.
Footnotes
1. www.teachmefinance.com/Financial_Terms/credit_crunch.html
2. Lecture given by John Blancett and Adam Barker of Sedgwick Detert Moran at Lloyd’s on 7.12.2007
3. Ibid
4 . http://www.globalresearch.ca
5 . Lecture given by John Blancett and Adam Barker of Sedgwick Detert Moran at Lloyd’s on 7. 12.2007
6. Timeline – The credit crunch of 2007
http://uk.reuters.com/article/personalFinanaceNews7 . www.thisismoney.co.uk/investing-and-markets/article.html
8 . www.telegraph.co.uk/money/main.html
9. http://business.timesonline.co.uk/tol/business/industry_sectors
10.www.thisismoney.co.uk/investing-and-markets/article.html
11 ibid
12. ibid
13 www.ft.com
14 http://www.iii.org/insuranceindustryblog
15 http://global.marsh.com/news/press/PRSubprimeCrisis20070820.php
16 http://dandodiary.blogspot.com/2007/11/subprime-litigation-wave-hits-citigroup.html
17 sgpropertypress.wordpress.com/2007/11
18 www.ft.com
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