Markets are filled with panic at the moment. News stories repeat ad infinitum projections that the current crisis is "the worst since the Great Depression". Some talk as if the collapse of capitalism itself is at hand.

How did it start?

Escaping the ‘rent trap’ … on easy terms

Home ownership has always been a highly valued goal. People in Australia, America and the UK in particular are extremely fond of the idea of owning their own home. Politicians encourage the idea as well because home ownership is believed to give people a sense of security and stability, and an appreciating asset for wealth creation.

In 1977, the Carter Administration passed the Community Reinvestment Act (CRA), which compelled the banks to make loans to low-income and minority borrowers, with the laudable aim of widening home ownership in the USA: in particular, extending mortgages into minority groups, which had usually found it difficult gaining home loans.

The CRA was not widely used until 1999 when the Clinton administration leaned on the government sponsored wholesale mortgage financier, Federal National Mortgage Association (usually referred to as "Fannie Mae") to make finance more readily available to minorities.

"Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans."

 Source: New York Times, 30/9/1999, "Fannie Mae Eases Credit To Aid Mortgage Lending"  

The strategy was a huge success, permitting millions of Americans buy their own home for the first time. Then in September 2001 following the terror attacks on New York and the Pentagon, interest rates were lowered significantly in order to stimulate the economy. Official rates dropped as low as 1%. With mortgage rates not a lot higher than that, and plenty of money fleeing the stock market, a tremendous boom in real estate began in the United States encouraging ordinary buyers, buyers with poor credit as well as investors to buy expecting huge future price growth.

Unsophisticated personal investors buying into the idea that property was an asset class with low or no risk and a high return was perhaps an inevitable consequence of such a long unbroken period of strong growth, but in time the idea even came to be accepted by financial institutions.

If prices are only going to rise then from a lender's point of view a mortgage default is not a major problem because the collateral property being sold will always be worth at least what was lent against it. While governments continued to provide various incentives to low income people to borrow, financial institutions became quite willing to lend to borrowers whose ability to keep up mortgage payments was not as strong as the typical borrower of the past.

Eventually in the United States credit standards became so lax that some lenders were willing to lend the entire value of a house to even borrowers with no provable income and little assets, at rates not greatly higher than those available to "prime" borrowers. These "NINJA" (No Income, No Job or Assets) loans came to be a small but rapidly growing segment of the mortgage business.

This was widely applauded by all concerned. Financial institutions made huge profits from writing more mortgages, mortgage broking became a boom industry and millions of people finally escaped "the rent trap" becoming home owners for the first time. Investors also, spurred on by virtually unregulated wealth creation gurus and recent history borrowed enormous sums of money in the expectation of almost unlimited capital gains.

Birth of a property bubble

Fuelled by all this activity, property prices were continuing to climb. After a while property looked very expensive and many potential buyers began to doubt the wisdom of buying when renting seemed much cheaper, at least in the short term.

The thing about affordability is that once something becomes too expensive for a typical buyer to afford it, typical buyers stop buying. First home buyers in particular stopped buying, which removed the engine driving further price growth. In many parts of the United States especially, but also in the UK and in Australia, prices stopped rising and even began to fall.

Without rising prices, the key justification for the lack of credit analysis (that the collateral will always be worth at least what the borrower borrowed for it) had vanished. The first cracks – default on mortgage payments -- began to appear; soon these cracks widened, becoming mortgage delinquencies, and foreclosures. Lenders, plus the investors who bought investment products and securities based on those loans, began to take losses.

Why defaults in mortgages led to a global credit crisis

One of the innovations which helped fuel the boom in lending was the repackaging of loans as securities for resale to investors.

The banks were organising loans just as they always did, but holding the loans on their balance sheets tied up a lot of capital and banks saw an opportunity to free up money so they could make more loans by creating investment products out of them and selling them to investors.

These products ranged from fairly traditional mortgage funds to very complicated credit instruments. The most infamous of these were the CDOs, collateralised debt obligations. Although CDOs have been around since the late 1980s, they only became well known by the late 90s.

A CDO is a financially engineered security made from pools of mortgages, bonds and other debt which are assembled and then dissected into various "tranches" or "slices" representing different ranks of security and returns. Based on financial models developed with long term historical default data, the banks were able to create a series of different securities offering different levels of risk and return.

A tranche designed to offer a high level of security would be last in line to take any losses from defaults and would be designed to have a projected level of risk low enough to be given a very high (AAA) credit rating. Less senior tranches would offer higher returns while taking on greater exposure to the risks. In this way a simple portfolio of loans and bonds could be transformed into a wide assortment of securities suited to investors of differing needs.

The fatal flaw of the CDOs though was that the tranches were calculated based on historical default and loan recovery rates which were not comparable. These historical default rates were based on a time when proper risk management was done and fewer loans were made to borrowers of poor creditworthiness. They were not designed to stay afloat with the large number of defaults that started occurring on all those NINJA loans. They failed because the assumptions which were used when creating the different tranches were not conservative enough.

AAA securities fail

The failure of a few CDOs wasn't unprecedented, but what was different this time was that the level of defaults were so high in some CDOs created during the last couple of years of the real estate boom that even the most senior AAA rated tranches were taking big losses. This was the start of the credit crisis.

A great deal of weight is attached to credit ratings and the fact that highly rated securities were getting wiped out, and the sad stories of risk averse investors from all over the world losing money they couldn't afford to lose sent a collective chill down the spines of credit investors everywhere.

On Wall Street there is a creepy old saying "there is never only one cockroach". It means that because ideas tend to be copied, when one scandal or disaster has been revealed, there are usually others lurking around the corner. If even a AAA rated CDO was capable of being wiped out then supposedly any CDO could be wiped out. Before long this idea morphed into a fear that most or even all CDOs might be wiped out. Investors simply stopped buying CDOs and similar securities.

Banks left holding the baby

The real problem was that even though investors knew that even in a severe financial downturn only a small minority of mortgagees would default on their loans, the fact that CDOs are complex and hard to value, combined with the discrediting of the valuation models they had been assembled with, CDOs came to be perceived as too risky to buy.

Banks owned large numbers of CDOs, some of which they had purchased from other institutions and some of which they had created themselves with a view to selling to investors. With a buyer's strike on mortgage securities, banks were left holding them and thus had money tied up in these securities instead of having cash to lend to more borrowers.

The banks also on average ended up owning lower quality securities than what was already in the market as they were made from mortgages written over houses at 2007 prices, as opposed to earlier mortgages which of course were written over houses at earlier and generally much lower prices.

Virtuous Circles turn Vicious

A few years ago a series of accounting scandals (Enron, Worldcom et al) led to the passing of new accounting rules that required financial institutions to value financial assets on their accounts at their market value. This rule was intended to prevent companies from using arbitrary high prices set by aggressive accountants to inflate their own balance sheets.

During boom times, few objected. Corporations' balance sheets swelled as the prices of securities increased. Banks are limited in the amount of money they are allowed to lend by the value of their assets. The more assets they have, the more they can lend. Inflating assets meant the banks were able to increase their lending.

But once confidence in CDOs was lost, banks had to write down the value of their assets. The problem was though that as the crisis worsened prices of CDOs fell further. This forced banks to sell some of their assets in order to boost their cash reserves. The selling put downward pressure on prices. As prices fell further banks were forced to liquidate more assets.

What started out as a notion with virtue was turning into a vicious cycle.

Hedge funds dragged into the vortex

Banks were not the only sellers. Hedge funds and other investors had been routinely gearing into assets like CDOs which until the downturn had been looked at as attractive and relatively low risk high return investments. A number of these funds had been using very high levels of leverage and when the assets fell in value they were forced to sell in order to meet margin calls.

The self-perpetuating cycle that permitted ever greater levels of lending had shifted into reverse. As banks took losses on their assets and had to apply those write-downs to their balance sheets they also had to slow or even stop their lending so as not to breach the limits on lending imposed by regulators. The number of loans being written dropped significantly, interest rates on loans rose even though official interest rates were falling, and borrowers with less than perfect credit found it almost impossible to get a loan at all.

The selling created more selling. When hedge funds were forced to sell securities in order to meet margin calls their selling helped push prices down further, prompting more margin calls. The falls were far from being confined to CDOs though. Frequently unable to sell their CDOs, banks had to sell whatever they could. Prices of debt instruments of all kinds fell, prompting margin calls among traders who owned those as well, forcing their prices down.

Stuck in this vicious circle, markets have suffered repeated waves of losses as banks and other institutions tried to deleverage themselves and raise cash. It would be perfectly fair to say that the vast majority of the price falls have been driven by this vicious circle rather than by any significant deterioration in the profits of any companies outside of the finance sector.

Indeed companies outside of the finance sector were fortunate enough to reduce their level of debts during the boom time. Levels of corporate debt are about as low as they have been in many decades and the levels of default among non-finance companies are still very low.

Stopping short sellers and the great Wall Street Bailout

Concerned that speculators had been influencing prices by aggressively short selling securities, regulators around the world put various restrictions on short selling.

A short sale is the sale of a security which you do not yet own in the hope that the security can be bought back later at a lower price. If the security falls, you buy it back more cheaply and pocket the difference. An investor that short sells a security that goes to zero makes 100% of the short sale price as a profit, however if the security rises, their losses are not limited.

Ordinary "covered" short sellers use borrowed stock certificates to settle their trades. Then when they buy the stock back again (this is called "covering the short") they hand the stock certificates they just bought back to the institution they first borrowed certificates from.

"Naked" short selling is done where the short seller sells a security without bothering to source a stock certificate. Naked short selling is mainly the domain of very short term traders who cover the short in the same day and thus have the stock certificate they purchased on the same day they are supposed to settle the sale. Otherwise, naked short sellers may simply pay the penalties for a failed settlement.

Believing that aggressive short sellers were contributing to the drops in prices, in late September 2008 regulators around the world simultaneously placed restrictions on short selling. Measures ranged from temporary bans on shorts in certain securities and/or bans on naked short selling which was perceived to be the greater villain, through to a blanket ban as imposed by Australian authorities on all forms of short selling for all stocks for a period of three months.

At the same time, there was a major announcement that the US treasury was contemplating a gigantic bailout package worth perhaps a trillion US dollars. It isn't at all clear whether it was the announced bailout package or just short sellers all piling in at once to cover their short positions but global stock markets rallied strongly in the next few sessions.

Then the US Congress failed to pass the rescue bill. The market once again began to slide. Even the passing of the bill in a slightly revised form several days later failed to ignite much enthusiasm. Retail investors pulled record amounts of money out of their mutual funds and stocks had one of the worst weeks since the crash of 1987.

What happened in October that caused a new panic?

Contrary to what one might think, this latest panic has had little to do with CDOs and sub-prime mortgages. The vast majority of losses from defaults on those debts have either already been incurred or have had provisions made for them by the banks involved. The market, well aware of those losses and potential losses, has probably fully priced those into its expectations and shouldn't react further to additional write-downs unless they are unexpectedly large.

The effects flow through the system

The latest downturn is causing a far greater level of distress in the market because of concern over the effect of guarantees issued over the creditworthiness of bond issuers. The latest villain in the piece was the Credit Default Swap or CDS.

A CDS is essentially an unregulated insurance contract on a bond. A CDS enables investors and speculators to make a bet on whether or not a company is going to go bankrupt. As a risk management tool they can be very useful. An investor who is concerned that a bond issuer may go broke can purchase this insurance with the CDS seller guaranteeing to make good any losses the bond holder experienced.

The problem though is that CDSs were not subject to regulation. It was up to the purchaser of the CDS to convince themselves that the seller of the CDS actually had the means to honour their obligation in the event of the bond defaulting.

When the investment bank Lehman Brothers collapsed, there was great concern that this could bring down other major players because the value of Lehman Brothers' outstanding bonds was huge; i.e. the total extent of bond losses was far greater than anyone had been expecting.

The risk is that if a CDS issuer goes bankrupt, all the insurance they had written would be worthless and other investors who had been relying on that insurance could then take enormous losses. Potentially the damage could have been like falling dominos as losses spread from one institution to the next.

Fortunately, the settlement of the CDS contracts happened last week (Friday the 10th of October) and seems to have gone off fairly smoothly. Apparently the issuers of CDSs had on the whole made adequate provision for their losses or had netted off their exposure by purchasing insurance themselves. It is likely that at least some of the heavy selling pressure of the previous two weeks was the result of CDS writers raising cash by selling off securities from their portfolios.

The problem now: no trust, no confidence

Right now the problem with markets can be characterised as one of a lack of trust and confidence. Banks aren't lending money to each other because they aren't sure about the safety of other banks. This means that commercial credit notes aren't being accepted. That is where this crisis has the most likelihood of spilling over from the capital markets to mainstream businesses.

For example, when an exporter is signing a consignment of goods over to a shipping company, the exporter expects that the importer at the destination has the funds to complete the purchase. Typically evidence for this is supplied in the form of a letter of credit from the other party's bank.

If the other party's bank isn't trusted though, the exporter won't release the goods. There are numerous anecdotes of large sales actually falling through, simply because one party didn't trust the other party's bank.

How the rescue package is supposed to work

What is necessary first is to reestablish confidence in cash in bank deposits. Around the world individually or in unison governments are stepping in to offer guarantees on deposits. If business and other depositors accept these guarantees then a major impediment to global trade will be removed.

The bailout package has been approved by Congress, though little money has actually been deployed yet. It takes time to properly plan what to buy to and organise deals, and the individuals running the rescue fund have been given a great deal of discretion to deal with the problem as best they see fit.

The initial proposal was to start buying mortgage securities off banks. Currently there is little buying activity and consequently even high quality mortgage securities are trading at heavy discounts to par value because the only prices being recorded are the firesale prices set during bankruptcies and takeovers. By purchasing a number of these securities, the Government can help reestablish an orderly market and hopefully prices of mortgage securities will increase, helping banks increase their net assets and thus improving their debt to equity ratio making the banks more solvent.

This proposal isn't necessarily going to result in huge costs to the US taxpayer. As Warren Buffett has pointed out in recent interviews, the securities on offer are trading at such discounts to par value that their yields are extremely high and an implausibly large number of defaults would be necessary for these investments to lose money. Buffett has actually said that if he had $700 billion to invest, he'd be willing to do the buyout himself. As it stands, he has been injecting money (some $8 billion worth and counting) into banks in the form of purchases of preferred stock at highly lucrative rates.

But purchasing mortgage securities isn't the only proposal. Direct injections of funds into banks via preferred stock issues are also being considered, as well as further guarantees of bank security.

The hope is that these measures will restore sufficient confidence in banks to stem outflows, put an end to indiscriminate selling to realise capital, and hopefully trigger the recovery.

 Are we near the bottom of the market yet?

Market timing is notoriously difficult and the only honest answer to "when will the market bottom" has to be "nobody knows". However, there is a consistent opinion being expressed by fund managers and researchers worldwide that prices are extremely cheap.

Price-earnings ratios are today as low as they have been at major market bottoms of the past. Although bank stocks are beaten and bloodied, they have had plenty of time now to estimate their likely actual losses from mortgage defaults and have declared these potential losses, making provision for them in their accounts.

The opinion of a number of well known ‘value’ investors is that there are enormous bargains on offer in the market and that purchases today will in all likelihood be highly profitable over the long term.

The problem is that economics and company earnings aren't the primary factor driving prices at the moment. Value investors believe stock prices are cheap but can't rule out the possibility of them getting even cheaper.

At the end of the day, we believe that history teaches us that the capitalist system is surprisingly robust and that crises always pass. Down markets have always provided lucrative buying opportunities to long term investors; Buffett advises: "Be fearful when others are greedy, and greedy when others are fearful" .

Markets have a tendency to rally very quickly, taking investors off guard. In truth nobody knows when this crisis will end and there have already been several times when the market seemed to be bottoming out, only for another realisation to send prices tumbling once more. Perhaps this time the level of pessimism was so great that the market can really be said to have capitulated. Markets always bottom at a moment of maximum pessimism and the pessimism lately has been comparable to that at any market bottom.

As we often ask rhetorically, if bear markets with low prices and abundant bargains isn't the right time to buy stocks for the long term, then when is a good time?

What positives are likely to come out of this?

• Better risk management and regulation of banks. In particular, banks are likely to be discouraged from making risky loans with regulations that force them to make greater provision for losses on risky loans and to retain some exposure to the loans they write, rather than simply selling them to securities buyers.

• Derivatives markets likely to be structurally reformed and better regulated with set up of central clearing house for all derivatives with proper margin facilities.

Timeline:

1999: In the US, under political and commercial pressure, Fannie Mae relaxes lending standards for low income borrowers. Millions of people buy a home for the first time including record numbers of minorities. What is at first a limited pilot program is rolled out across the country. A multi-year real estate boom begins in the US, Australia and the UK during which time lending standards progressively get weaker, culminating in loans given to "NINJA" borrowers - no income, no job or assets.

2005: House prices peak in the US and begin to fall in many areas.

2006: Falling house prices and financial distress for overstretched mortgagees leads to increasing numbers of sub-prime borrowers defaulting on their mortgages.

February 2007: HSBC announces huge loss provisions made to cover bad mortgages following their disastrous acquisition of US Sub-Prime lender Household International.

June 2007: Two Bear Stearns hedge funds which had bought CDOs collapse, markets become worried that the risks had been underestimated.

August 2007: French Bank BNP Baribas suspends withdrawals in three investment funds with no obvious link to US sub-prime mortgages. Paranoia sets in as investors start to realise that risks are not just confined to sub-prime debt securities.

September 2007: Northern Rock, a major British mortgage lender, fails and is taken over by the Bank of England.

2007 - 2008: House prices and prices of CDOs and other instruments continue to slide causing numerous banks to declare huge writedowns. By the end of the year, total losses were around $500 billion. Banks were forced to try to raise capital, taking in some $350 billion by August 2008.

March 2008: The situation seemed to be quietening down, but the sudden failure of hedge funds Peloton and Carlyle Capital sent a chill through the markets. Soon after that, Bear Stearns collapsed and was acquired in a deal brokered by the US Federal Reserve by JP Morgan at a price which valued Bear Stearns' stock at less than 10% of its value before the collapse.

March - June 2008: Falling prices and sub-prime debt writedowns continued steadily but once again there was a growing sense that the worst was behind us.

June 2008: Lehman Brothers announces a $3 billion loss, once again sparking panic in markets.

June - September 2008: a number of small aggressive lenders collapse followed by the giant US Government sponsored mortgage financiers Fannie Mae and Freddie Mac, which were soon taken into conservatorship by the US Government.

September 2008: Lehman Brothers files for bankruptcy. Merrill Lynch avoids a similar fate with a takeover by Bank of America. Financial stocks come under enormous pressure and then AIG, the world's largest insurance company, is given an $85 billion emergency loan by the US government and issued equity leaving the US Government with a 79.9% stake in the insurance giant.

10 October 2008: Lehman Brothers credit default swaps are settled. Bond holders paid 8c in the dollar with the remainder to be paid by CDS issuers. Prior to this event markets were falling fast and had lost over 15% that week, however as news came out that the CDS settlements had gone smoothly the market rallied somewhat toward the end of the session, clawed back the losses of the morning and closed more or less flat for the day.

13 October 2008: The combined effect of rescue packages being announced by governments all over the world, interest rate drops, government bank guarantees and the smooth settlement of Lehman Brothers' CDSs have been warmly received by the market. Overnight the S&P500 index rose nearly 12% and Australian stocks rose 5%.

Post 13 October 2008: In the weeks since the 13th of October, prices have continued to fluctuate. Markets are several percent higher at the time of writing than they were then, but there is still plenty of volatility.

Glossary of terms:

CDO: Collateralised Debt Obligation, a synthetic security created out of a pool of debts, split up into various slices or "tranches" of differing risk and return profiles. More senior tranches are the last to suffer a loss if there are defaults in the loan portfolio, but have the lowest return. Higher returns are offered by the less senior tranches, but these are first in line for the losses.

CDS: Credit Default Swap, essentially an insurance contract on a bond where the issuer of the CDS guarantees to pay the buyer of the CDS in the event that the bond's issuer goes bankrupt.

Fannie Mae: folksy name given for the Federal National Mortgage Association, a major supplier of finance for mortgages in the US, able to secure debt very cheaply due to government sponsorship.

Freddie Mac: The Federal Home Loan Mortgage Corporation, a rival to Fannie Mae.

Prime mortgage: a mortgage issued to a person with a good credit history and high level of ability to service a mortgage.

Sub-prime mortgage: a mortgage issued to a person whose credit history and payment abilities are inferior to a prime mortgage customer.

Short selling: selling a security you do not own in the hope that it will fall in price and can be bought back later on. The profit is the amount you get to keep after buying the stock back more cheaply.

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