It is instructive to reflect on two of the primary causes of last year’s credit and liquidity crisis, because they provide pointers to two areas where significant medium- and long-term implications can be foreseen. The initial trigger for the crisis was a growing awareness of serious structural problems in the US subprime- mortgage lending sector.

Over the previous two or three years, lenders had increasingly been advancing finance to borrowers with poor credit histories, and on the basis of sometimes dubious evidence of income and assets. For example, some borrowers obtained loans on a “stated income” basis. This generally meant that only a portion (e.g. 80 percent) of the borrower’s income was verified by the lender. The remaining 20 percent was not verified. There is increasing evidence of borrower fraud relating to the stated income product, and allegations—at the least—of complicity on the part of vendors’ agents. In addition, much lending was done at very high loan-to-values (on the assumption that rising housing prices would self correct the underwriting).

As attractive initial repayment rates reverted from low fixed levels to high and variable market rates, many thousands of borrowers found they could not manage. Defaults, foreclosures and repossessions mounted. Many mortgage lenders with heavy exposure to the subprime sector were forced into bankruptcy. Billions of dollars of losses were suffered by overextended borrowers, concentrated in lower-income groups who could least afford them.

Had this been the only trigger, the impacts may have been contained, and confined to the US housing and mortgage markets. But the critical factor which allowed the contagion to escape and infect financial markets across the world was widespread securitization and selling-on of mortgage loans.

This had two consequences. First, the impact of losses spread progressively through the international financial system. More significantly it became increasingly difficult for financial institutions to assess accurately the extent of their potential exposure or put a firm value on the risk they were carrying. Unsurprisingly, confidence collapsed, and lenders became unwilling to provide liquidity to borrowers carrying potential liabilities.

Over time, liquidity will return, where necessary helped by judicious underpinning of the markets by central banks. Institutions have already written down close to $100 billion of value from loans and securities linked to the crisis. However, in the two fundamental areas at the heart of the crisis, long-term structural changes are almost inevitable; it is unlikely that the markets will return to previous conditions.

The retail credit market has already tightened dramatically, with lenders applying much more stringent credit criteria. Many individuals with poor credit scores are now finding it difficult or impossible to obtain significant credit. Among other consequences, this will progressively make it more difficult for them to refinance existing low- and fixed-rate mortgages when they revert to standard variable rates. It is unlikely that such marginal groups will enjoy the same access to cheap credit as they did before the crisis, at least any time in the next few years.

Similarly, it is unlikely that the securitization market will reopen to the full range of opportunities as existed before the crisis. A lesson has clearly been learned about the risks of buying packages of undefined and hard-to-value securities. Controls will be tightened. Auditors will be more vigilant in probing the bases of valuations.

Wider impacts are more difficult to predict accurately, and it is tricky to separate out the relative contributions of different drivers.

In addition to the funding and lending impacts of the crunch, capital management will play an increasingly important role. Banks that can manage capital and grow capital without diluting the returns to existing shareholders will thrive in the new environment. In the last few months, we have seen banks withdraw share buybacks, issue debt/equity hybrid instruments and issue fresh stock to strengthen balance sheets. It is also likely that we will see banks withdraw from or sell businesses that don’t provide a sufficient return on capital or whose earnings are too volatile to support within a tight capital range. Banks need this capital, otherwise they will find themselves unable to grow their lending books.

Nonbank lenders have flourished in an environment where funding has been cheap and plentiful. Nonbank lenders are now faced with significant challenges to their business model. Securing funding will be the top of their list. Funding may be obtained through finding shareholders with deep pockets such as sovereign wealth funds or building strategic alliances with parties who are naturally long funds. The credit crunch has brought the downfall of some companies around the globe. Companies that will continue to be at risk are those that have invested heavily in new businesses at high prices with short-term funding. The big uncertainty is over the R-word. Sentiment has clearly turned bearish, and the risk is that the markets will talk themselves into a recession. As yet, the consensus seems to be that there will be an economic slowdown over the forthcoming year or so, but no serious contraction. However, the debt-financed consumer boom is effectively over.

This article is an excerpt from a thought leadership document entitled Frontiers in Finance (March 2008), written by Simon Walker, partner at KPMG UK, and Peter Russell, partner at KPMG Australia.

The information contained herein is of general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

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After the crunch, where now?

It is instructive to reflect on two of the primary causes of last year’s credit and liquidity crisis, because they provide pointers to two areas where significant medium- and long-term implications can be foreseen. The initial trigger for the crisis was a growing awareness of serious structural problems in the US subprime- mortgage lending sector.