Inflation, stagflation and money supply

Italy’s Finance Minister, Tomasso Padoa-Schioppa, in mid April, told a gathering in Washington DC, of the International Monetary Fund’s governing body, that the sub-prime mortgage fiasco was not a unique problem for the global economy. Elaborating, he declared that there were several other obstacles on the path to global economic growth, including high US consumer spending, low interest rates and the lax lending that accompanied those rates.

So what exactly happened?

The sub-prime catastrophe centres on the United States housing market, but its effects have spilt over into credit markets and stock markets. What’s unfolding today is a result of what transpired immediately after a bunch of Muslims left their calling cards in Lower Manhattan.

Saturated with post terror trauma, the United States Federal Reserve System - facing an already struggling economy - began slicing rates dramatically. The so-called “Fed’s Fund Rate” fell to 1 per cent in 2003. The aim of which was to pump more money into the economy, which in turn, it was felt, would stimulate lending by banks and borrowing by individuals.

Was the Federal Reserve right?

Well, the strategy worked like a charm. The economy began to grow in 2002. Lower interest rates meant existing home borrowers could borrow more. Naturally, this led to rises in house prices. And those with poor credit ratings, who previously couldn’t borrow, suddenly found themselves being offered mortgages.

Happy days were here again.

New products, new problems

New financial products were being devised by Wall Street and old ones were being renovated, the most prominent of which was the so-called asset backed security (ABS). This new instrument ended up being marketed as “investments” to superannuation funds, hedge funds, foreign governments and even to local councils in Australia.

Simply put, an ABS is a bundle of assets that has consistent cash flows (such as an individual's home mortgage). Individual payments (mortgage payments, for instance), are aggregated with other recurring payments (of different types) and used to pay investors a coupon. The ABS is backed by the underlying property.

The advantage for the investor is that she can acquire a diversified portfolio of fixed-income assets that materialise on her bank statement as a single coupon payment. Pretty nifty, huh?

With the bubbling US real estate market, on the back of lower interest rates, a new form of ABS was created. Only these turkeys were being stuffed with more than their fair share of sub-prime mortgage loans, that is, loans to home buyers with dubious credit rating. Some securities were highly rated, some not, depending on just how much sub-prime stuffing was inserted into the ABSs.

When home prices stopped rising and inflationary expectations ramped up interest rates, many borrowers (who really had an awful credit rating and should never have been offered a mortgage in the first place) could no longer afford to make their mortgage repayments and were left with a mortgage bill bigger than the value of the house. This is politely called “negative equity”.

Problems ensued when lenders, facing no buyers for these bundled securities, were cut off from what had become a main funding source and were forced to close their doors. As a result, their stockpile of such and similar securities went from being easily traded to thinly traded to unmarketable.

Stuck with products they didn’t want and whose values were plunging, many lenders dumped these securities at great discounts in a mad dash for cash. Most opted for government debt. Yields on treasury bills (the inverse of their price) fell a whopping 1.5 per cent in a matter of days, given the massive interest in them.