US Subprime: History of the Credit Crunch and Credit Crisis, Part 3
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Geneva, 3 nov 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.
Geneva, 3 nov 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.
Part 3: CONFIDENCE
The whole financial system is based on confidence. It starts with you and me. When we have our salary paid into a bank, we do so because we are confident the bank will honour our cheques and card payments and that their ATMs will deliver.
Banks earn money by lending our hard earned cash and that of our companies to other entities. They lend to home buyers, to businesses and to other banks and they do so in the confidence that they will receive interest and be able to get the money back, or in case of default, own an asset of equivalent value.
As we have seen above, banks can borrow more money than is deposited and lend that out as well. The majority of bank lending is long term. For the system to work, the banks have to be able to raise money to meet short term obligations. They can borrow from the Central Banks short term, but most of the borrowing is between banks.
Crisis of banking confidence
When Leman Brothers went bust, the banks realised they could not rely on the government to bail out a troubled bank and knowing that there were still huge unquantified losses on bank balance sheets and that the credit default insurance market had collapsed, no bank could be confident that even a big name bank would be able to return money it borrowed.
Immediately, the banks stopped lending to each other. Without the ability to raise capital, the banks stopped lending to the public and to businesses. So we saw panic amongst the banks that created an immediate credit crisis. There was no longer any confidence in the banking system and so governments have been forced to step in.
Crisis of business and stock market confidence
The next crisis of confidence came amongst corporations. Companies were having trouble obtaining loans and then suddenly found their banks reneging on commitments already made. Credit lines were withdrawn or called in. Companies could no longer be confident of being paid by their customers and were also finding some of their suppliers going out of business.
The stock market was quick to recognise the implications of this and confidence in share prices slumped. Most of the world’s stock markets were down 20-30% over the past year and then panic set in last week. Markets dropped by another 25-30%. Most western markets are currently sitting some 40% below their highs of a year ago and the remerging markets have dropped up to 60%.
Iceland becomes bankrupt
In some cases, the market capitalisation (share value) is less than the asset value (buildings, stock, cash etc) of the company. The sudden drop in share value is causing problems for investment banks who have invested in corporations. This triggered the collapse of the Icelandic banks.
They had embarked on an ambitious program of raising money by offering interest rates in the region of 15% -16% and the UK government encouraged local authorities to deposit their money with Icelandic banks. The Icelandic banks invested this money in British and other overseas companies. They had taken on collective debt exceeding 4 times the Icelandic gross domestic product (GDP). When share prices collapsed, they became insolvent and the Icelandic government does not have nearly enough money to bail them out or to guarantee depositors. The country is bankrupt and the obvious place for it to turn is to the IMF.
So a vicious circle starts to build. The credit bubble burst and confidence has evaporated. Banks have no confidence in each other and so cannot lend and this has a knock-on effect to mortgages and property prices, to everyday business between companies and then on to all asset prices. We have seen it move from a loss of confidence to blind panic.
Clive Ward, Guest Contributor for EconomyWatch.com
Sources: Financial Times, The Times, Steve Sjuggerud Daily Wealth, International Monetary Fund website, Time Magazine
Clive Ward is a director of Affinity Consulting Group Ltd (ACG) and of Ganoz Asset Managment Ltd (GAM). ACG provides investment advice, financial planning and portfolio management services and has offices in Singapore, Dubai and Shanghai. www.affinity-consulting.com
GAM manages a range of high yield, automated, technical trading forex
