National Blog of New Zealand

“Neither a borrower nor a lender be” was the advice given by Lord Polonius at Act I, Scene III of Shakespeares Hamlet. It is said that Polonius, the mouthpiece of this advice, was created by Shakespeare so as to mock those dispensing such homespun wisdom. With this in mind I’m going to profer a little advice of my own, never ignore the central tenets of risk and return.

Looking to the origins of the global credit crisis it boils down to a bunch of less than ideal NINJA-esque loans being made, securitized, that is packaged up and sold onto other institutions. Believing that property prices which backed the loans would continue in an upward spiral as they had done for the last 50 years lenders provided these ‘subprime’ loans, borrowers took them up on their cheap credit and investment banks bought all the cashflows. Credit ratings agencies with conflicts of interest gave the securitized mortgages higher ratings than their risk profile warranted. Some institutions such as AIG insured the banks to remove the risk involved in purchasing the securitzed loans effectively linking the entire banking sector with credit default swaps. The constant theme through all of this is that risk is inadequately assessed, and returns set too low accordingly.

As we know when the US sneezes the world catches a cold. Problem is the US hasn’t just got a cold this time, it’s got yellow fever. The US NBER announced officially that the US is in recession and on cue both US domestic and world markets took a steep dive, with the DJI down 7.7%, S&P500 down 8.93% and the Nasdaq faring even worse. The NZX was down 1.17% for the day.

Figures show that 1.2 million US jobs have been lost so far, China’s factory output is falling, NZ housing construction is down, NZ house prices are estimated at 30% above long term trendlines (Barfoot & Thompson annoucing a 56% drop in house sales), all of this is making investors cautious about acquiring anything, let alone consuming and we’re now all just parking cash in ‘risk free’ government bonds or government insured deposits.

Interestingly as NZ banks come to refinance their offshore borrowing NZ’s AA sovereign credit rating may take a hit. The new wholesale bank deposit scheme creates a large contingent liability on the governments books, and the risk that banks are unable to refinance their debt due to the credit crunch may mean lenders demand higher returns from the NZ government. And this is how the system should’ve worked in the first place.

When return no longer bears upon risk and vice-versa the system falls apart.