Mumbai: As we start 2008, the global financial system is facing an unprecedented crisis, a crisis that threatens to down the shutters at mortgage firms and banks, and leave others badly bruised, saddled with billions of dollars of bad debts.
The problem started with the US housing market, where a lot of imprudent loans had been given to borrowers who couldn’t afford to repay them. When interest rates started climbing and house prices started falling, the bubble burst.
Thanks to financial innovations such as securitization, banks that made these faulty loans sliced them up, mixed them with good loans, got them rated by rating agencies and sold them to other banks all over the world. And because money was plentiful and interest rates were low, banks lapped up these “assets”. Also, because the bad loans were mixed with good ones and given a high credit rating (on the premise that only a percentage of the “subprime” loans went into default) many banks, insurance firms, pension funds, state governments and other buyers went the whole hog and bought them.
The result? Slices of these bad loans ended up in the portfolios of financial institutions across the globe and nobody has a clear idea of how much of this toxic paper is held by whom. Add to that the proliferation of derivatives on these loans which, too, are now affected by the meltdown in the values of the underlying assets and we have a situation of tremendous uncertainty in the financial markets.
The upshot of all this has been a series of write-downs by banks as they try to spot their bad assets and mark them to market. But, the problem has been exacerbated by the fact that the market in many of these instruments has disappeared because of the panic. Banks are, therefore, not willing to lend to each other and interbank lending rates, seen from rates such as Libor (London interbank offered rate), have shot up. And, if banks stop lending to each other, they can collapse. That’s why central banks across the world have stepped in and pledged to provide additional liquidity to banks.
Ramdeo Aggarwal
MD, Motilal Oswal Securities Ltd
One, a housing slump sends the US into a recession and, since the US is the main engine of world economic growth, this could slow the global economy. Former US Federal Reserve chairman Alan Greenspan recently warned that the US has a 50% chance of a recession.