The Credit Crunch is still spreading around the world. These disturbing events are the consequence of actions by a wide variety of characters.

1. House Buyers

The first group of actors to arrive on the credit crunch stage were the home buyers who pushed house prices up to record levels. They believed that house prices would always go up and never go down. Housing is the ultimate safe investment. Their faith has now been destroyed as house prices have fallen dramatically over the last year.

My father used to say,

When times are good, people think they will last forever. When times are bad, people think they will last forever.

He had observed this with his own eyes. His Father had brought a farm during the post-war land boom for £20 per acre in 1925. The Great Depression destroyed that optimism and by 1940, the same land could not be sold for £12 per acre. The price only got back to £20 per acre in the mid-1950s, after the wool boom caused by the Korean War. Thirty years went by before prices returned to the level that they had been in the previous boom.

For the rest of my father’s long life, land prices continued to rise, but he knew the boom would not last, just as the slump in prices did not last. Nothing lasts forever. Good times and bad times always end.

Home buyers in America who thought that house prices would always go up are finding that they were wrong. The same thing may be now happening here, as the steam has gone out of the property market.

Home buyers speculating on ever-rising house prices were foolish.

2. Mortgage Brokers

Once upon a time when you wanted to borrow money through a mortgage on your house, you went to a bank, but things have changed. Over the last couple of decades mortgage brokers have sprung up. Borrowers liked them because they took away the formidable task of dealing with the bank. In fact they go round all the banks and get the best deal for you.

The banks like the brokers because they took over the task of completing all the paperwork and assessing the creditworthiness of borrowers. Soon most of this work was outsourced to the mortgage brokers. Countrywide Financial became largest mortgage broker in the United States.

The problem with this model is that mortgage brokers work on commission. They get a fee for every mortgage they sell, but they carry no risk if the mortgage goes wrong. This gave them an incentive to organize mortgages for people who could not afford them. The mortgage broker got their fee and someone else would have to deal with the mess when the mortgage turned sour. They were not accountable for their actions. Soon the Ninja loan emerged, lending large amounts to people with no income, no assets and not jobs, in the hope that their mortgage would be taken care of by rising house prices. Applications in which people lied about their income also slipped through.

Mortgage brokers were irresponsible. The consequences will only come to light, if houses prices fall significantly or unemployment increases. As Warren Buffet said, “You only find out who has been swimming naked, when the tide goes out."

3. Securitisation

In the good old days, you got your mortgage with a bank. They paid their depositors about 3% interest and charged about 5% interest on house mortgages. The margin between 3% and 5% covered the risk and provided the traditional bankers with a reasonable income. However, this margin is not sufficient to sustain the lifestyles of the whiskey-drinking graduates of Harvard and Princeton who moved into investment banking in recent years. They had to find a way to squeeze more out of the margin between lending and borrowing. Competition prevented them from pushing up the interest rate paid on mortgages, as home buyers were shopping around for the best deal. The only way to increase the banker’s margin was to reduce the cost of the money they were lending.

Securitisation was the answer. The bank takes all the mortgages on their loan book and wraps them up in one security, commonly called a Mortgage Backed Security (MBS). An MBS uses hundreds of mortgages as collateral and the interest payments from the mortgagors provide a steady stream of income. Securitisation has two benefits for the bank. Risk is reduced, because even if one mortgage turns sour, the others will cover it. Managing one security is cheaper than managing thousands of small depositors, so the cost of funding is reduced. This allowed the bank to squeeze a bit more out of the 3% to 5% margin. The other benefit was that these securities could be sold to a Pension Fund or Hedge Fund and moved off the banks balance sheet (more on that in a couple of days).

The problem with securitisation is that the owner of the MBS bears the risk of defaulting mortgages, but is too far removed from the process to understand the risk they carry. By separating those who scrutinise borrowers from those who carry the risk of default, securitisation reduced accountability.

4. Investment Banks

Securitisation opened up another way to squeeze a bit more out profit out of the 3% to 5% margin. Investment Banks got in on the act and started creating various synthetic securities called Collateralised Debt Obligations (CDOs) that restructured the MBSs by splitting the risk into high and low risk tranches. The low risk tranches came with an AAA credit rating so the cost of funding was further reduced, providing more profits for the bankers.

The problem with these CDOs is that they soon became so complicated that no one, not even their creators, understood the risk. Everyone just assumed that all these instruments were risk free, but no one really knew. Of course we all know now that there much more risk left, than investment banks realised.

The investment banks were either naïve or arrogant.

5. Mathematicians

For most of history, mathematicians have been boring and poor. Then a couple of mathematicians named Black and Scholes were awarded the Nobel Prize in economics for coming up with a clever model to assess the value of a security.

No one knew the value of many of the synthetic securities created by the investment bankers. Some clever mathematicians saw an opportunity to escape the ignominy of academia, so they started applying their complex mathematical Black Scholes models to mortgage backed securities. Bankers and financiers did not have a clue what these entities were worth but the mathematical geniuses came up with a number that looked credible.

The wonderful thing is that these models took the risk of default into account. Everyone assumed that risk was under control. This was good for the bankers as they could squeeze a little more profit out of the 3% to 5% margin - until the finance markets clogged up. Suddenly the mathematical models no longer produced sensible results and no one had any idea about the value of many securities.

Gretchen Morgensen wrote in the New York Times:

As of last Nov. 30, Bear Stearns had on its books approximately $46 billion of mortgages, mortgage-backed and asset-backed securities. But who knows what those mortgages are really worth? According to Bear Stearns’ annual report, $29 billion of them were valued using computer models ‘derived from’ or ‘supported by’ some kind of observable market data. The value of the remaining $17 billion is an estimate based on ‘internally developed models or methodologies utilizing significant inputs that are generally less readily observable.’

Mathematicians are less dangerous when they are boring.

6. Credit Rating Agencies

Margins on mortgage lending are tight, so the best way to extract more profit is to reduce the cost of funding by reducing risk. The credit rating agencies, like Moody’s and Standards and Poor’s had developed sound reputations over many years of assessing the creditworthiness of corporations and financial institutions. They started assigning their rating to Mortgage Backed Securities and Collateralised Debt Obligations.

An AAA rating from one of these agencies increases the value of a security and reducing the cost of borrowing, because investors just assumed that these AAA rated securities would never lose value. The increase in profit received by the investment bank more than covered the cost of obtaining the credit rating.

The credit rating agencies earned enormous fees and the investment banks gained more profit. Everyone was happy… until houses prices dropped and foreclosures increased. Suddenly, the risk attached to the mortgage based securities has increased significantly. Now it is becoming clear that the credit rating agencies had totally misunderstood the quality of the securities they were assessing. Many of these securities still have an AAA credit rating, but everyone knows that they not a safe investment.

The credit rating agencies were naïve or devious.

7. Monoline Insurance Companies

The monoline insurance companies like Ambac and MBIA got started insuring municipal bonds against default. This was a profitable activity. They took in regular insurance premiums and only paid out if the municipality or bond issuing institution were to default. This rarely happened, because these organisations do not default, they just raise taxes. Monoline insurance was a great line to be in. Premiums rolled in and very little money rolled out. It rolled into the owners' pockets.

The municipalities benefited too, because their bonds took on the AAA rating of their insurers, so they got very low interest rates on the money they borrowed. These companies are called monoline, because federal laws prevent them from going into general insurance.)

However, the Monoline insurers were ambitious to expand their profitable business into other fields. They saw all the securities being offered by investment banks as a good opportunity. Soon they were offering insurance against default on the variance MBSs and CDOs. The banks enjoyed this too, because any action to reduce risk would allow them to squeeze more out of the 3% to 5% margin that limits the profits that can be made from mortgage finance.

While property prices were going up, the monoline insurers had a great business. They took in even more premiums and they hardly ever had to pay out, so profits the profits kept rolling in. But then house prices fell, and defaults followed right behind. Now the monolines had to make payouts to the owners of securities subject to default. The payouts were soon larger than their reserves and their capital. Ambac will only survive, if it can sell $1.5 billion in stock to expand its capital.

The various municipalities have also suffered. They took on the AAA rating of the monolines. However now the monolines have had their credit ratings down graded severely. This also down grade the rating on the bonds of the municipalities they insure. These organisations are now paying higher interest rates, because they are theoretically more risky.

The monoline insurers tried to insure risk that was bigger than they were.

8. Freddie Mac and Fannie Mae

The normal way to reduce risk in America is to get the federal government to ban the cause of the risk. That was beyond their powers in this case, but they gave the world Freddie and Fannie.

Banks and mortgage brokers attempt to reduce the risk on mortgage debt by selling it to Freddie Mac and Fannie May, the lending agencies sponsored by the federal government. The assumption has been that be this eliminates risk, because the federal government is guaranteeing the debt. Not really.

William Poole, the President of the Federal Reserve Bank of St. Louis, gave this warning about Fred and Fan.

An understanding of the risks facing Fannie Mae and Freddie Mac – which I will sometimes refer to as "F-F" to simplify the exposition – is important from two perspectives. First, investors should be aware of these risks. Although many investors assume that F-F obligations are effectively guaranteed by the U.S. Government, the fact is that the guarantee is implicit only. I will not attempt to forecast what would happen should either firm face a solvency crisis, because I just do not know. What I do know is that the issue is a political one, and political winds change in unpredictable ways.

These federal agencies create a false sense of security, but the implied guarantee could have an enormous cost. If it were to be honoured during a collapse, the American tax payer would pay the bill.

The value of Fred and Fan shares has been declining rapidly. No one knows how this will end, but one think is certain. The risk that was supposed to be eliminated will be born by someone and that someone is likely to be the same taxpayers who are struggling to pay their mortgages.

Politicians think they can legislate risk away.

9. Leverage Kings

In the end, the margin between 3% and 5% was just too small to sustain the life styles that bankers deserve, even after all the efforts to expand the margin by reducing risk. So they came up with one more trick. Many of the mortgage backed securities and CDOs were sold to hedge funds and sundry other investment vehicles. The trick was that these companies became highly leveraged by borrowing most of the money they used to buy these securities. By most, I mean about 95 percent.

The benefit of this high gearing is that the profits are multiplied by the degree of leveraging. In this case the margins are small. These institutions were able to squeeze a large profit from a low margin by being highly leveraged.

Here is an example. If is spend $1000 on a bond with a 4% percent yield, I get a return of $40 on my investment. I can increase my return by getting a loan of $3000 from my bank at 3 percent interest to buy more of the bonds with the 4% yield. The return is now (1000 x 0.04) + (3,000 x (0.04 - 0.03)) = 40 + 30 =70. This is a 7 percent return on my investment of 1000. The loan has nearly doubled my return, even with a gearing ration of 4 to 1.

If I increase my borrowing to $30,000, my return is (30,000 x (0.04 - 0.03)) = 40 + 300 =340. A leverage ratio of 30 to 1 increases the return on my investment of $1000 to 34%. You can see the appeal of high leveraging. A high return can be obtained, if the margin of the yield over the cost of funding is quite small.

High gearing is fine while the activity remains profitable. When losses strike, the leveraging works in the same way to amplify any losses. If in the last example, the value of the bonds that I have bought drop and my yield of 4% turns into a loss 10 percent, I have to deal with a loss of $3,000. My original capital is totally wiped out and I still have to pay $2,000. Not quite so nice.

This is what happened to several of hedge funds and investment vehicles. When the securities they had bought declined in value, their margin disappeared and turned in to a large loss.

These funds had borrowed the money they used to buy their securities from commercial banks, using their securities as collateral. When the value of the collateral decline, the banks demanded that they reduce the size of the loan or come up with more collateral. However, they could not produce more collateral, because their leveraged losses were chewing up their small capital.

High gearing is fine while an activity remains profitable. When losses strike, the leveraging works in the same way to amplify the losses. This is what happened to several of these funds. When the securities they had bought declined in value their margin disappeared and turned into a large loss.

Carlyle Capital fell into this trap. It controlled $21.7 billion in AAA rated mortgage debt issued by Freddie Mac and Fannie Mae. It had leveraged aggressively, borrowing $31 for each dollar of capital. When its investments lost value the banks started worrying about their debt exposure and demanded that Carlyle Capital put up more collateral for the loans. A $150 million credit line from its parent, the Carlyle Group, was not enough to keep it out of trouble and a couple of weeks ago it collapsed.

Bear Stearns got into trouble by lending money to two funds that it had set up to buy mortgage backed securities using bank debt. It then had to take the debt and the low-value securities back onto its own balance sheet. It never recovered.

Most investment banks are highly leveraged. According to the Wall Street Journal, Morgan Stanley, Bear Stearns and Lehman Brothers are also leveraged by more than 30 to 1 Merrill Lynch and Goldman Sachs are leveraged more than 25 to 1.

Sometimes the securities bought with leveraged capital are CDOs that already have some leverage built into their construction. In some cases the resulting effective leverage is over 50 to 1. This produces enormous profits in good times, but a drop of 2 percent in asset values can wipe out the capital of the investors.

High leverage amplifies profits, but it also amplifies the losses.

10. Leverage went Everywhere

Leverage has leached into every corner of life.

• A young person buys a new television with no deposit, no interest and no repayments until 2010.
• A woman who inherited a house from her parents uses the equity to buy four more.
• A hedge fund uses bank credit to amplify the profit from trading in shares and commercial paper.
• A young man leases a new truck from General Motors for three years.
• A young woman maxes out four credit cards to spend $20,000 on a trip to Asia.
• A new married couple takes a 100 percent mortgage to buy their first house.
• A church pays for a new building with a mortgage, assuming that future tithes will pay the interest.

Leverage was not exclusive to investment banks. Everyone go in on the act.

11. Alan and Ben and the Foreign Men

The reason that bankers were able to lend so much money to the hedge funds and sundry investment vehicles was that the Federal Reserve has been pumping money into the economy for most of the decade. The big commercial banks had large amounts of money sloshing round in their coffers that they were only to glad to lend to highly leveraged hedge funds.

Thus it was Alan Greenspan and Ben Bernanke who allowed the high level of leveraging to occur. Every time they increased interest rates, the leveraging increased. There are two reasons. Firstly, as interest rates fall, yields fall, so profits are harder to make. Secondly, debt is cheaper. The fall in yield can be compensated for with an increase in leverage.

At the same time, China has kept its currency low to encourage exports to the rest of the world. One consequence was that the Chinese monetary authority was left with large volumes of dollars to invest. They chose to invest in US treasuries. The government of oil exporting countries also had huge surpluses to invest. All this cash eventually ended up in the vaults of the bankers, who quickly moved it on to the hedge funds and investment vehicles.

Alan and Ben empowered the credit bubble.

12. Men in Brown Suits

The shenanigans of these credit crunch characters cannot change reality. Banking is quite simple. Banks borrow money from one group of people and lend to another. The difference between the interest they pay on what they borrow and the interest they get on what they lend is their margin. The profits of banks depend on the size of their margin and how well they manage the risk of defaults on their loans.

House prices can go up and house prices can go down. People make mistakes, so the risk of mortgage lending can never be eliminated.

The credit crunch will destroy the dreams and ambitions of the clever people who thought they knew better. The world will be safer when mortgage lending is managed by bankers in brown suits who understand the risks of lending and whose lifestyle does not require them to squeeze enormous profits out of small margins.