How the financial dominoes tumbled

By Tamsyn Parker

The financial meltdown of the last week has hammered home the predictions of many who said there was more fallout to come from the US credit crunch.

But for those not so closely embroiled in the goings-on of Wall St and the financial markets it's hard to know how we have got to a point where some of the world's most well-known banks and insurance companies are going under.

Who would have believed two years ago that Britain's Halifax and Bank of Scotland (HBOS) group - the UK's biggest mortgage lender, would come to a point where it would need to be bailed out through an emergency cash injection from Lloyds TSB?

Or that American International Group (AIG), a global insurance firm with US$1 trillion ($1.48 trillion) in assets, would have to be stopped from going bankrupt with an emergency loan from the US Federal Reserve.

So how did we get to this?


Many analysts now link the origins of the sub-prime crisis and the resulting credit crunch to the tech sector boom and bust and the 2000-03 recession.

The emergence of the internet led to the launch of a huge number of internet-based companies in the mid-to-late 1990s.

Then, as many of the businesses went bust, the bubble burst in 2001. About a year earlier the US began heading into recession following a boom time in the 1990s fuelled by low inflation and low unemployment.

There were large lay-offs as companies sought to cut costs by outsourcing jobs. To try to stimulate growth in the economy the US Federal Reserve began to cut interest rates in May 2000, cutting them 11 times between then and December 2001 to drop the rate from 6.5 per cent to 1.75 per cent.

This made the cost of money very cheap for banks and in turn for borrowers, setting off a worldwide housing boom. House prices rose phenomenally and so did the number of mortgages given to those with poorer credit histories.

These high-risk mortgages or sub-prime mortgages were given to people with low incomes, poor credit histories - many of whom would not otherwise have been able to borrow from a main trading bank.

While not a huge part of the entire mortgage industry, sub-prime mortgages proliferated in the early part of the decade. According to Moody's Investor Services about 21 per cent of all mortgage originations from 2004 through to 2006 were sub-prime, up from 9 per cent from 1996 through 2004.

Sub-prime mortgages totalled US$600 billion in 2006, accounting for about one-fifth of the US home loan market.

In late 2005 the housing bubble burst as too many houses flooded the market and too few buyers were able to afford to buy. The downturn in the housing sector then continued to worsen over 2006-07 and has yet to have reached the bottom. The plunge in existing home sales is said to have been the steepest since 1989.


A number of people with sub-prime mortgages began defaulting in 2006 but a second wave of defaults in 2007 was much worse. The sub-prime loans were given at a set rate for several years similar to a fixed-rate mortgage.

But to help combat rising inflation in the US the Federal Reserve began increasing interest rates in 2007 which meant many of those with sub-prime mortgages who were coming off a fixed rate faced a jump of several per cent in the level of interest paid on the loans.

A level which many could not pay.

The defaults ballooned and began to spread into prime mortgages. The US Treasury Secretary called the bursting housing bubble "the most significant risk to our economy".

In February to March of 2007, 25 sub-prime mortgage lenders collapsed. In April New Century Financial - the US's largest sub-prime mortgage lender, filed for Chapter 11 bankruptcy. During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity, up 79 per cent from 2006.


While the first to be directly impacted were those who lent out the money, many of those lenders also passed on the risk through creating specialised financial products.

Through a form of financial engineering called securitisation they passed the rights to the mortgage payments and related credit risk to third party investors via mortgage-backed securities (MBS) and collateralised debt obligations (CDOs). Mortgage-backed securities are when mortgages are pooled together and sold as an investment product on the open market.

Fannie Mae and Freddie Mac were both set up by the US Government and later privatised to do exactly this. In March 2006 the MBS market was estimated to be worth US$6.1 trillion.

CDOs package together a whole lot of different types of fixed income assets including mortgages and sub-prime mortgages. They are broken up depending on the risk of the asset - the higher the risk, the higher the interest payment on the asset.

In 2006 the size of the CDO market was estimated close to US$2 trillion.

But corporate, individual and institutional investors holding MBS or CDO investments faced significant losses, as the value of the underlying mortgage assets declined.


Sub-prime mortgage backed securities were discovered in portfolios of banks and hedge funds around the world, from BNP Paribas in France to Bank of China.

The widespread dispersion of credit risk and the unclear effect on financial institutions caused reduced lending activity and increased spreads on higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was affected.

This has set off a chain reaction of collapses throughout the world. The Federal Reserve has cut interest rates and poured money into financial institutions to keep them afloat. But some have suggested this has just delayed the inevitable collapse of those companies who had massive exposures in these areas.


Despite a massive bailout of Fannie Mae and Freddie Mac in early September the last 10 days has seen more carnage with Lehman Brothers filing for bankruptcy, Merrill Lynch bought out by Bank of America and Lloyds TSB's bailout of HBOS.

The Federal Reserve has also now had to become more picky about who it rescues choosing to let Lehman Brothers fall while rescuing AIG.

But the Lehman bankruptcy will also trigger defaults by other firms. It has US$62 billion of credit default swaps - where investors buy insurance against a default - which are unlikely to be paid out on.

Those who also provided insurance against Lehman going under to other financial institutions will also have to pay out and deals where Lehman was a counter-party - a seller of a swaps contract - will also be affected.

But the Fed had to balance this out with the fact that AIG has $441 billion in exposure to credit derivatives - a lot of which was with banks which would have taken a big hit if it went under.

But nobody knows where the next domino in the line will fall.

- NZ Herald

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