“You need to keep as many people as possible in their houses so that they don’t come onto the market. You need to arrest the decline in house prices, but you also need to prevent human suffering and social disruption because it’s going to be very, very severe.”

Billionaire investor George Soros on the US subprime housing crisis. New York Review of Books, 15 May 2008

“For the first time in our company’s history, our board is paying attention to credit management,” one credit manager told me last week.  Two months of the worst debt figures his company has ever seen mean that he has the go-ahead to employ more staff.

It’s obvious that New Zealand faces hard times.  Petrol and food prices are rising.  Unemployment is up.  But really, it’s what happens overseas that determines how bad this gets.

How bad is it going to be?  Most of those who know, don’t want to say for fear of depressing the economy further.  Are we heading for a 1930s-style depression?  What are the implications for New Zealand businesses and particularly for those trying to collect debts?  I don’t want to spread doom and gloom – I was much more optimistic by the time I’d finished writing this article than I was when I started the research – but I think we need a realisticunderstanding of what’s happening.

The story starts in the 1980s, when banks in the US started selling their home mortgages. They packaged up bundles of mortgages into ‘mortgage bonds’ and Wall Street traders sold them to investors. The home owners kept paying the banks, and the banks passed the money on to the bond holders.

Of course, if any homeowners didn’t pay, their houses would be sold in mortgagee sales. If the mortgagee sales didn’t cover the value of the debt, the investors lost out. Rating agencies such as Standard & Poors and Moodys gave the bonds a creditworthiness rating so investors could understand the risk and decide what the bonds were worth. Today, the mortgage bond market is worth US$6 trillion, the biggest single part of the US$27 trillion US bond market.

House prices in the US rose steadily from about the start of the 1990s. Roughly 5 years ago, ‘subprime’ home loan lending took off in the US. This is lending to higher risk borrowers who wouldn’t normally get mortgages. These loans, too, were on-sold as bonds.

By 2005, one in five mortgages was subprime. About six million people who had little or no money borrowed around 100% of the value of a house, at about the top of the housing market. From 2006, house prices dropped sharply and it turned out that millions of credit decisions, and the ratings of the agencies, had been poor. Many subprime borrowers have lost or will lose their homes.  Of course, that hits investors who own subprime mortgage bonds and banks which lent to those investors.  Of the banks, those in the US were hit hardest.  To pick just one example, in November 2007, Chuck Prince, the CEO of US bank, Citigroup, the world’s biggest bank, resigned as the bank estimated that it had lost up to US$11 billion on investments related to sub-prime mortgages. European and Japanese banks have also suffered.

Many bond investors reduced the risk of non-payment of their bonds with contracts known as ‘credit default swaps’ (often known as CDS). CDS work like this – the owner of bonds pays the equivalent of a premium to another party, which has to pay out on any default on the bonds, like an insurance company would. But insurance companies are regulated to make sure they have the cash to pay claims. CDS are traded on a ‘grey’ market on a huge scale. They are widely used to speculate on market changes and they are not regulated. In June 2007, the Bank for International Settlements reported the notional amount on outstanding over-the-counter CDS to be US$42.6 trillion.

This looms as another disaster for financial markets. The party which is supposed to pay out on a default may turn out not to have the money or may not be around to pay.

Bear Stearns – the fifth largest US investment bank and the ninth-biggest player in the CDS market – is still around, but only just.  In March 2008, the company had a US$10 billion run on its funds as investors lost confidence and pulled their money out.  On 16 March, to avoid bankruptcy, the firm was sold to another Wall Street trader, JPMorgan, for 1.3% of its market value of a year earlier. The sale was backed by an unprecedented US$29 billion of special financing from the US government. The government did this to prevent havoc in financial markets.

At the homeowner level in the US, the news is equally bad.  In a speech on 4 May 2008, Ben Bernanke, Chairman of the US Federal Reserve, said that, “About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure…  [F]oreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.”

Mortgagee sales reduce house prices even further. Then banks like Citigroup find they need to make further write-offs. In January, two months after estimating losses of up to US$11 billion, Citigroup wrote off US$18 billion in bad investments. At time of writing, its losses totalled US$40 billion.

These sorts of banking problems have meant that banks have been generally unwilling to lend to other banks, a major problem for the banking system. No-one knows how bad anyone else’s problems are going to be, and who they can trust.  Everyone is therefore struggling to find the money they need.

The US economy is in deep, deep trouble. Is this the start of a 1930s-style Great Depression? In April, the International Monetary Fund warned that America’s mortgage crisis has spiralled into “the largest financial shock since the Great Depression” and said there is now a one-in-four chance of a full-blown global recession (which the IMF defines as less than 3% world growth) over the next 12 months. So they’re not yet talking about a depression (a severe economic downturn that lasts several years) but it could be a global recession if we’re unlucky. 

Here are some of the positives. First, the major credit markets are starting to recover following the rescue of Bear Stearns. The Wall Street Journal on 15 May said, “A significant improvement in the credit markets since late March is emboldening more companies to undertake acquisitions and share buybacks that will be financed largely with debt.”  There is still caution, but investors are becoming more willing to borrow, and banks more willing to lend.  The US Federal Reserve is stepping up as lender of last resort for a wider range of financial institutions and is prepared to accept a wider range of securities as collateral.  This has been positive and economists hope that it proves to be the circuit breaker.

This is evidence of a second positive factor: Governments and central banks know a lot about dealing with financial crises. After the Wall Street crash of 1929, the US central bank did more to exacerbate the problem than to fix it. By contrast, in the last six months, central bankers have bailed out banks, lowered interest rates, and increased the money available.

For example, in March 2008, a group of central banks in North America and Europe said that they would inject US$200 billion into money markets.  And in April 2008, consumers in the US received more than US$100 billion in tax rebates – up to US$600 for individuals and US$1,200 for couples – as part of a plan to stimulate the economy.

The third piece of good news is that the world economy doesn’t depend on the US as much as it used to.  In 1929, the US economy was much more important, so when it failed, the whole world went into a depression.  Today, the annual gross domestic product of the US is actually exceeded by that of the European Union (though the EU has its own, somewhat less serious problems housing finance problems), and there is substantial wealth elsewhere.

It’s significant that when Citigroup sought to raise $12.5 billion at the end of 2007, it got the money from such sources as the Singapore government’s investment arm, the Kuwait Investment Authority and prince Alwaleed bin Talal of Saudi Arabia.   A report by HSBC in February 2008 says that “…huge quantities of money from the emerging world – some $60bn at the last count – are injecting a measure of stability into the developed world’s arteries [meaning Citibank and others].”

Merrill Lynch chief Asia economist Timothy Bond was quoted in The Australian on May 15 2008 saying, “Europe has been the main driver of Asian exports over the past few years, not the US.”  Asian economies expanded 9.5 per cent and China grew by 11.5 per cent in the second half of last year, he said.

And closer to home, Westpac is bidding to buy Australia’s fifth-largest bank, St George, a clear sign that Australian banks (which own our major banks) are not that worried by the problems in the US.  Our banks have not been directly affected by the US subprime mortgage problems, though the fallout has caused them some problems.

Clear-sighted billionaire George Soros, one of the world’s most successful investors and now one of its most influential philanthropists, wrote an article in the Financial Times on 22 January called “The worst market crisis in 60 years”.  Clearly Soros thinks the problems are serious, but he saw hope:

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

So he thinks the West faces a recession but it won’t be worldwide, and when we come out of it the US probably won’t be the world’s leading economic superpower.   These are changing times we live in.

So what does this mean for those involved in credit management?  Well, imagine you are collecting subprime mortgages in the US.  You have lots of customers who can’t pay.  If you seize their homes, homeless people will trash the empty houses.  When they’re sold – if they’re sold – it will be for bargain prices which will help drive the housing market lower.  And then there’s the social cost…  It’s not just the borrowers who are between a rock and a hard place – the creditors are too, and so are their collection staff.

The majority of New Zealand credit staff will be too young to remember the crash of 87 and the hard times of the early 90s. Collecting debts in a recession is not the same as collecting in good times.  If there is a recession, there will be more good customers who go bad, more stressed and angry customers, and more threats of violence or self-harm.  If your usual assumption is that people bring their problems on themselves, you should put that aside.  In these circumstances it’s even more important to treat debtors with respect.  Bad things can happen to good people.

In a recession there will be more debts sent to debt collectors, more legal action, and more debtors entering into some form of insolvency. “Over the next 12 months we expect to be inundated with debt to collect,” says industry veteran Bob Garters of debt collection company, RML.  There will also be more people who decide to set up as debt collectors, on the incorrect assumption that it’s an easy way to make money in tough times.  As Garters points out, it’s already much harder to collect debts, both consumer and commercial, than it was six months ago.  It is likely to become harder still.

There will be more pressure to negotiate practicable payment arrangements and more need to vary contracts to avoid having to repossess and sell worthless goods.  Businesses which can afford help customers through tough times should find that they build strong loyalty.

Not only will there be more debts but negotiations will take longer.  Because there is more work, more staff will be required.  In some businesses, sales staff with time on their hands will end up doing collection work.  “Sales in my area are drying up so I’m helping out by making collection calls for the credit controller,” a salesman explained to me at a collection seminar this month.

Speed in following up on unpaid accounts is crucial.  Credit staff who take a hard line early on will sometimes get paid where others miss out.  Of course, in other cases they will upset customers who survive. So the ability of credit staff to assess the person and the situation they are dealing with is also crucial.

The problem for reasonable creditors who negotiate fair payment arrangements with their debtors is that they may find that other creditors are unreasonable.  The reasonable creditor’s arrangement falls over and the money goes to the creditor who sued, or in some other way took a hard line.  Creditors should be aware of the legal options for compromise arrangements and the orderly distribution of payments to creditors.  Voluntary Administration (VA) for companies, is a new process, introduced in November 2007 and barely used since then.  It can be triggered by the directors of the debtor company or any secured creditor.  Most creditors who supply goods will be secured creditors.

For individuals, a Summary Instalment Order (SIO) allows debtors with unsecured debt of less than $40,000 to pay it off all or part over up to 3 years.  The process was revamped in December 2007.  Robyn Cox of the Insolvency & Trustee Service says that to the end of April only 30 orders have been made!  Demand for SIOs must be driven by budget advisers, but they don’t seem to have taken to it.

The new SIO rules were introduced at the same time as the much more popular No Asset Procedure (“NAP”).  This is a 12-month bankruptcy alternative for debtors with debts below $40,000 and with no assets and no worthwhile income. The NAP is not administered by the Official Assignee because, with no assets or income, there is nothing to do.  The fear of creditors is that debtors will abuse this.  One creditor quotes an Otaki voluntary budget adviser who told one of her staff, “I just love the No Asset Procedure because I am really sticking it to all those finance companies at the moment…”  Others report debtors starting to use it as a threat to creditors:  “If you don’t give me more time I’ll just take a NAP.”

Robyn Cox says that numbers of debtors using the process to date has been relatively low, though rising.  She stresses that the Insolvency & Trustee Service is very keen to make sure that creditors have faith in the system.  “If a creditor tells us that a debtor has run up debts recklessly or lied about their assets or income we will look at terminating the NAP,” she says.

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