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How a subprime apple contaminated global finance

©

Text by Clea CAULCUTT

Latest update : 2008-12-10

The worldwide financial crisis that threatens to plunge leading economies into a prolonged recession stems from a relatively localised housing crisis.

How did the crisis start?

In the mid-1990s, encouraged by low interest rates, US banks began offering mortgages to “subprime” borrowers, people whose low incomes or unreliable borrowing histories had previously made them ineligible for mortgages. These high-risk loans often had “adjustable” interest rates, which started low but could rise sharply in later years.

Much of the high-risk mortgage debt was transformed into mortgage-backed securities (MBS) which could be exchanged on stock markets. The high-risk MBS’s were often packed into sophisticated financial products and sold off to financial firms and insurance companies around the world.
 
However, in late 2006, interest rates rose and poor households across the US struggled to pay off their mortgages. Many of them went bankrupt and lost their homes - an estimated 1.2 million nationwide.
The subprime market’s collapse

As default rates on subprime loans shot up, investors lost confidence in subprime loans and related financial products. Investment banks, which provide financial services (unlike commercial banks), tried to get rid of stocks based on these high-risk housing loans. Panic gripped stock exchanges and the value of MBS’s, whose cash flows are backed by the principal and interest payments of mortgage loans, plummeted.
 
The first victim of the subprime crisis was Bear Stearns, which closed two funds with significant subprime investments in July 2007. The plummeting value of MBS’s raised fears of a credit crunch, a situation in which banks are reluctant to lend each other money, reducing the amount of credit available for the business loans that keep an economy growing.
 
The subprime contagion spreads
 
The crisis started in the US but quickly spread around the world. Banks which had invested in subprime lending were some of the first victims of the crisis. After Bear Stearns' bad news it was Swiss banking giant UBS which announced it was writing off $10 billion on US subprime market losses in December 2007. In February 2008, the UK government decided to nationalize Northern Rock, a banking group specialized in housing loans, to save it from bankruptcy.
 
The crisis did not end there. In September 2008, several financial firms and insurance companies hit rough waters. First, the US government had to bail out mortgage giants Fannie Mae and Freddie Mac on Sept. 7. A week later, Lehman Brothers, the fourth-largest investment bank in the United States, filed for bankruptcy after it failed to find a backer willing to come to its rescue.
 
On Sept. 17, the US government decided to take an 80 percent stake in American International Group (AIG), a major insurance company on the brink of collapse, offering up an $85 billion loan.
 
World stock markets were hit hard on news of the ailing financial groups. When Lehman Brothers filed for bankruptcy, Wall Street saw its worst day of losses since Sept. 11, 2001. Asian and European stocks also sank.
 
Central banks to the rescue

 
In a first move to forestall a credit crunch, the world’s central banks decided to inject funds into money markets. In August 2007, the European Central Bank (ECB) injected 95 billion euros into money markets to calm investors following BNP Paribas' decision to close three of its funds. In September 2008, the US Federal Reserve System injected $180 billion into money markets in the wake of AIG’s near-collapse. The Fed had agreed to distribute the money to other central banks and private banks in need of dollars.

On Oct. 3, the US House of Representatives passed an unprecedented “bailout” of the financial sector, the Emergency Economic Stabilization Act of 2008. Designed by US Treasury Secretary Henry Paulson, the plan authorizes the US Treasury to use up to 700 billion dollars of public money to buy up the Wall Street banks’ bad debts, allowing them to remain solvent.

The plan did not immediately succeed in restoring confidence on the world’s stock markets. After posting dramatic single-day falls - some of the worst since the stock market crash of the late 1920s - central banks and governments across the globe coordinated efforts to provide a lasting solution to the crisis.

This involved huge cash injections into the financial system, often resulting in full or partial nationalisations of major banks.

The British government said it would use 50 billion pounds (64 billion euros) to buy stakes in HSBC, Royal Bank of Scotland, Barclays, HBOS, Lloyds TSB, Standard Chartered, Abbey and Nationwide Building Society.

Iceland, battling national bankruptcy, nationalised the country's three biggest banks.

Elsewhere, the Belgian, French and Luxembourg governments rode to the rescue of struggling bank Dexia, pledging to guarantee money it borrows on the markets.

And in a concerted action on Oct. 8,  the US Federal Reserve, the European Central Bank, the Bank of England and central banks in China, Sweden and Switzerland all joined the new interest rate offensive, cutting rates by half a percentage point.

How can this affect me?

Those first affected by the financial system’s troubles are the sector’s employees, notably the thousands of Lehman Brothers employees who have lost their jobs, but many more job cuts are expected on Wall Street and the world’s stock exchanges and financial firms.  “Everyone working in the London circuit is really worried about their job now. As banks and mergers disappear, thousands of posts go with them,” Yann H., a young trader formally with Goldman Sachs, told FRANCE 24.

However, the prospect of job losses is not limited to traders and brokers.  Alessandro Giraudo, an economist and author of "Legends and Myths in Economics", says the financial system will not crumble, but conceded to FRANCE 24 that the current crisis “will just force people to slow down and take less risks.”

The simultaneous move by central banks to inject funds into money markets is aimed at preserving the flow of credit, that if plugged will force businesses to stall their activities, and could result in the bust of more companies. Those struggling to find work because of job cuts or hiring freezes, and worried consumers in general, are certain to spend less on goods and services, driving down sales and extending revenue losses to small to mid-range businesses.

While central bank injections reassured panicky stock markets and calmed credit crunch fears, they do not offer long-term solutions to the risky mechanisms of the financial system, which even with the central banks’ aid is uncertain to recover completely.

These massive injections of public funds mean that, in the long term, taxpayers and consumers could bear the brunt of the crisis as inflation rises and public deficit increases.  Rising inflation means a general rise in the level of prices of goods and services, which can hurt consumers who have already felt the surge in energy and food prices worldwide.

 
The dark spectre of recession hangs over the economies of the industrialized nations as a result of the crisis.
 

Date created : 2008-09-19

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