The Financial Crash in Plain English

Credit crunch. Bear Stearns. Fannie and Freddie. Lehman Brothers. AIG. Following years of feverish expansion, the global financial system is having a fit.

Due to the low interest rates, banks were aggressively lending, especially for housing. Cheap funds fuelled big gains in house prices.Eventually, banks ran out of good customers to lend to, and started doling out money to people with poor credit records who had little hope of repaying their debts - no credit rating and no stable income. Bankers were lending because they thought the houses were very good collateral; in case of default, the price of houses were more than the mortgages.

Bank then rolled up these risky loans (‘subprime mortgages’) into mortgage-backed bonds (IOUs). They waved a magic wand and turned these bonds into highly rated securities. These were sold to other banks, insurers and pension funds around the world.

Unfortunately, inflation went up. By 2006, the Federal Reserve had to increase the rates. In June 2006, the cost of funds for prime rate was 8% (end 2002 was 4%).

This resulted in heavier mortgage payments for many house owners and they could not pay. Many had to forego their properties. The banks took over the houses and this created a slump in the market. As house prices started to fall, the value of bonds backed by subprime mortgages started to slide. The investors (banks, insurers and pension funds) stopped buying these papers causing the market for mortgage-backed securities to grind to a halt. This prevented selling banks from selling on loans, thus restricting their ability to continue lending. Thus, what could have been a local problem has escalated into a global drama. (Systemic risk)

As banks grew anxious about each other’s exposure to these toxic loans, they became increasingly wary of lending to each other. Thus, inter-bank lending (‘wholesale lending’) dried up in early August 2007. Within a month, this ‘credit crunch’ had claimed its first scalp in the UK – Northern Rock.

Although clever banks had sold on much of their subprime lending, many kept the supposedly choicest cuts for themselves. Then as house prices slid, the loans turned nasty and the US banks started to lose tens of billions of dollars.

In March, Bear Stearns, was rescued by JPMorgan Chase with government backing. The next bailout was on the two biggest players in the American mortgage market, Fannie Mae and Freddie Mac. A week later, Lehman Brothers, America’s fourth-largest investment bank, collapsed into bankruptcy. Next up was AIG, the world’s largest insurer, which received an $85-billion bailout in return for giving the US government an 80% stake in the firm. Meanwhile UK’s biggest mortgage lender, HBOS, is being taken over by rival Lloyds TSB. It not the end yet! More names will be inducted in the Hall of Shame.

The bad news is that very few people will be entirely immune from this financial meltdown. Thanks to these poisonous loans, banks worldwide have already lost over £250 billion. Even worse, this loss could double or quadruple before things improve. Hence, in order to rebuild their capital and profits, banks must increase lending costs.

Therefore, thanks to interest-rate hikes, borrowers are being hit hard. Nevertheless, as the economy slows down, rising bad debts will take their toll, forcing lenders into further rounds of rate rises.

Likewise, homeowners and property investors are suffering a double whammy, thanks to falling house prices, higher mortgage rates and a steep fall in the availability of home loans. In addition, stock-market investors around the world have suffered as economies begin to slow, company profits slip and share prices dive.

Rising inflation (higher prices) is undermining the value of the Ringgit in our pocket. Keen spenders will find retail therapy much less affordable, thanks to falling disposable incomes. Finally, falling company profits and the economic slowdown will lead to lower tax revenues. With public spending rising relentlessly, the government will have to milk taxpayers harder in order to avoid a huge budget blowout.