What has driven the Credit crunch

Just my opinion you understand, but I have this little theory. One fo the problems with the world's investment business, and particularly the big investment banks is the extension of what used to be the Private Client Asset Management business.

The Private Client business used to be exemplified by the likes of Global Asset Management or GAM (who reallypioneered a lot of this stuff), who were one of the first Hedge Funds. Unconstrained and largely unregulated they had very stringent entry requirements and offered exceptional returns for a very select group of customers. This was a very niche part of the investment business and didn't really have any great effect.

However through the 90's GAM and many others started offering the kind of returns, 30% p.a. to a wider group of investors, who understandably leapt at the chance, who wouldn't want to double their money every three years after all.

So there was an explosion in both money (every 3 years it doubled!) and clients. This produced the "wall of money". This was the immense amount of very liquid funds that were being invested in a largely unregulated way by commission driven hedge funds.

The hedge funds remember don't get paid just on managment fees, on no, they get paid a high percentage of their growth as well. "2 and 20" is the norm where a Hedge Fund will get 2% management fee and 20% of growth. So the incentive to produce high return is huge.

As nature abhors a vacuum, ways were found to satisfy the requirements. This led to the increasing securitisation of assets, so that banks could trade stuff that they owned (so you can trade the bond that is backed by the asset) which allied with low capital cover requirements meant that you could create up to 20-30 times the value of the asset. So if you had a 100k mortgage as an asset, you could lend 2-3 million on that. So suddenly you had loads of cheap money, so what do you do with it, lend it to people to buy property after all property is a safe as houses right?

The result is rising property prices, which fuels more money, and more loans, etc. without generating any extra value (a house that rises in value by 100% doesn't generally double in size!). Apparently these are known as non-income generating assets.

This is fine while nobody has to look at the downside, after all asset values are rising so no-one has to worry. The problems occur however, when asset values start falling because when things start falling, people want to sell, and to do that they need to know the value of what they are selling and all of a sudden everyone realised that they didn't know the value of the stuff they were trading (it may have been rated as AAA, but what was it really worth). This is especially true when the loans are packaged up and sold with different risk assesments (this bit of the loan book is AAA, this bit is AAB etc.) and there are no clear differentiators in the book.

So the banks stop trusting each other (my loans are crap, theirs must be too).

Oh dear.