Anatomy of a global credit crisis

How did a sharp rise in US home loan defaults trigger a collapse in confidence that continues to cause massive volatility on global debt and equity markets? By Sean Farrell and Danny Fortson


What is going on in the debt market and why should I care?

The debt market is what makes the financial world go round, providing credit for governments and companies to invest and individuals to buy houses, start up businesses and fund their education. The market has become more complex as investment banks dreamt up new investment products based on these loans, which investors lapped up in search of high returns.

After years of relaxed lending, the market has suddenly seized up, triggered by rising defaults by "sub-prime" US mortgage borrowers. As these defaults mounted, institutions rethought their attitude to risk and suddenly became scared of losing money. Banks became unwilling to lend to each other for fear of not getting their money back. The panic has spread to shares, and there are fears that the panic could spread from financial markets to hit the wider economy.

What is a sub-prime loan and why have they caused all this trouble?

A sub-prime loan is made to someone with a poor or limited credit record. These loans can be extremely profitable for the lender, who will charge a higher price for the extra risk involved. In the US, vast numbers of mortgages were sold to low-income families attracted by very low "teaser" rates. Many of these loans were made based on borrowers' own accounts of their financial affairs, with no proof required. As interest rates rose and the introductory rates expired, borrowers who had chased the dream of home ownership found themselves unable to afford repayments and started defaulting on the loans.

The sub-prime problem has caused panic beyond the US because, instead of holding loans on their balance sheets, lending banks have been offloading them to investors. In a global market for debt, financial institutions almost anywhere in the world could have taken on the risk of the loans in return for what seemed an attractive return.

How was this allowed to happen?

Investment banks have come up with ever-more ingenious ways of packaging up debt and selling it on to other financial institutions such as hedge funds, banks and insurers. This was meant to make the financial system more stable by dispersing risk and reducing the chance of a single bank being sunk by bad debts. But being able to offload debt encouraged some lenders to loosen their lending standards and make loans to riskier borrowers.

It is not just loans to individuals that have been packaged up in this way. Corporate loans are also turned into securities and sold on in the market, leaving the lending banks with fat fees for arranging the finance but minimal exposure to the risk. In particular, banks have fallen over themselves to lend billions of dollars to private equity firms that have used the borrowed money to fund takeovers of companies. The market panic has caused investors to stay away from these loans, leaving banks with $300bn of unexpected debt.

What are these ingenious products and structures and how do they work?

The basic concept is "securitisation" - parcelling up loans as bonds and selling them into the market, allowing the lender to free capital and transfer risk. This can be done with assets such as mortgages, credit cards, leases and corporate loans.

But it gets more complicated than that. To make risky assets like sub-prime loans more attractive, investment bankers have packaged them up with higher quality loans into derivative products called collateralised debt obligations (CDOs) that were given high ratings by agencies. But as sub-prime defaults increased, investors found themselves sitting on explosive losses from what they thought were low-risk investments.

The panic has also thrown the spotlight on the asset-backed commercial paper market. Basic commercial paper is an IOU issued by a company or bank to fund its business, typically for three months. In the asset-backed commercial paper market, (ABCP) banks set up "conduits" - off-balance sheet investment vehicles - which make investments and then issue short-term IOUs to investors to cover their funding needs. But with the underlying assets sometimes including sub-prime mortgages, the $1.1 trillion ABCP market has dried up with investors refusing to buy paper backed by both risky and low-risk assets.

Wasn't this meant to have dispersed risk throughout the financial system?

That was the idea, but it turns out there is no such thing as a free lunch. Using impenetrable financial instruments to sell risk in the global market may have spread it around, but no one knows where it is. Few people paid much attention to IKB until the German bank said earlier this month that it could lose billions of euros from investing through a conduit in sub-prime assets. With trouble popping up in unlikely places, the market is running scared.

Also, many of the buyers of sub-prime loans and leveraged debt were hedge funds, to which banks had lent huge sums. With banks suddenly demanding more security from hedge funds and some investors in hedge funds pulling out their investments, some funds have had to sell assets off quickly.

And, having offloaded these debts through the front door, it turns out banks have let them in through the back by using their conduit vehicles to invest in mortgage-backed securities, CDOs and other risky assets.

Why is the crisis of confidence so acute?

The panic has spread beyond sub-prime because people have decided that assets in general were not "priced for risk". Suddenly, banks and the investors to whom they have been selling all stripes of debt in recent years, have lost faith in what they are buying. Many of the big banks know that like themselves, their rivals have off balance-sheet conduits that are in some cases chock-full of CDO's and other debt instruments that are so much toxic waste. What no one knows however is just how bad it is, or how widely spread the damage will be. So until some clarity emerges, everyone is battening down the hatches. Private equity firms have shelved takeover plans, banks have stopped lending, and debt investors aren't interested in taking on any more. Instead widespread de-leveraging is occurring, as investors reduce their debt levels that reached unsustainable levels after years of incredibly low interest rates.

Couldn't someone have spotted this earlier?

Rating agencies such as Moody's and Standard & Poor's, whose job it is to gauge the credit-worthiness of companies as well as financial instruments, granted most CDOs the same rating as US Treasury Bonds, considered the safest of investments. The European Commission has since opened an investigation into whether they sounded the alarm soon enough, and the US authorities are also expected to examine the issue when Congress returns from recess. Critics say the ratings agencies are inherently conflicted, raking in huge fees to value the CDOs and other asset-backed securities conjured up by their clients. The agencies worked closely with the banks to ensure an air of security to a sector that was anything but.

A few lonely voices had raised a flag earlier on including Anthony Bolton, investment supremo at Fidelity, and Warren Buffett, the Oracle of Omaha. However, bankers and investors were content to march gleefully forward on the belief that the economic cycle had been smoothed, they said, by the opening of new markets abroad and the spreading of risk around the world.

What can central banks do?

Central banks such as the European Central Bank, the US Federal Reserve and the Bank of Japan injected hundreds of billions of dollars in short-term funds as a lender of last resort to desperate banks. The Bank of England said yesterday that it lent £314m last week at a penalty rate to a bank or banks who had nowhere else to turn.

The US Fed slashed the rate at which it lends to other banks by a half per cent last week, and later said that it was standing by to provide longer-term financing for needy borrowers. The question, however, is whether the Bank of England, the Fed or the ECB will have to take more drastic action to jolt the financial system back into life. This could come via a cut in the base interest rate. In the UK, the BoE Governor Mervyn King has given no indication of a willingness to swerve from the bank's plan to push through at least one more interest rate rise.

How bad could it get?

It is a classic case of the adage: "When America sneezes, we catch a cold." The credit turmoil that began with individual Americans failing to make payments on high-interest loans has already spread to the equity markets in Tokyo, London and the rest of Europe. Last week, the FTSE had its single largest one-day fall in more than four years. Investors are fleeing risky assets in droves. Earlier this week yields on three-month US Treasury bills - a safe haven investment - fell to their lowest levels since 1982.

The financial services industry in the City of London comprised an inordinate proportion of the overall UK economy--about a tenth of the national GDP. If a slowdown occurs here, the knock-on effects for the rest of the country would be widespread. Not least would be the housing sector, which has been propped up especially in the Southeast, by City workers armed with bulging bonuses. In the UK house prices are showing the first signs of slowing after more than a decade of growth.

Credit crisis: a bluffer's guide

Credit Market

The global market for loans and derivative products based on these loans, which can be bought and sold by banks and large investors.

Debt Securitisation

The packaging up of loans into bonds that are sold on to investors, transferring the risk from the lending bank's balance sheet to the investor.

Mortgage-backed Security

A bond that packages up mortgage loans and uses the repayments to pay investors a return.

Collateralised Debt Obligation

CDOs are investment products that parcel up different grades of credit - from highly risky to safe - in a way that gains them high credit ratings.

Slice and Dice

Grouping of different asset classes into a new instrument designed to get a top credit rating.

Commercial Paper

Unsecured IOUs issued directly by companies to fund their short-term needs, typically three months but sometimes longer.

Asset-backed Commercial Paper

IOUs sold through a conduit or structured investment vehicle, backed by assets such as mortgages, leases or credit card payments.

Conduits/Structured Investment Vehicles

Investment vehicles that banks keep off their balance sheets and fund through the asset-backed commercial paper market. Conduits' assets can include CDOs, credit card debt, personal loans and mortgages.

News
people
News
Michael Buerk in the I'm A Celebrity jungle 2014
people
News
news

Lincoln MP Karl McCartney 'denied all knowledge' of the Twitter activity

News
The author PD James, who died on 27 November 2014
people

Detective novelist who wrote Death comes to Pemberley passed away peacefully at her home, aged 94

PROMOTED VIDEO
Arts and Entertainment
Joel Edgerton, John Turturro and Christian Bale in Exodus: Gods and Kings
filmDirector said film would 'never have been financed' with ethnic minority actors in key roles
Life and Style
View of champagne glasses at a beach bar set up along the Croisette during the 66th edition of the Cannes Film Festival in Cannes on May 17, 2013
food + drink(and for now, there's a clear winner)
News
Happy in his hat: Pharrell Williams
people
Arts and Entertainment
Avatar grossed $2.8bn at the box office after its release in 2009
filmJames Cameron is excited
Arts and Entertainment
Jennifer Lawrence as Katniss Everdeen in The Hunger Games: Mockingjay Part 1
arts + ents
Life and Style
tech

Sites using the popular Gigya comment platform were attacked by the Syrian Electronic Army (SEA)

News
ebooksNow available in paperback
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Senior Execution Trader

£30000 - £250000 per annum: Recruitment Genius: A global Rolling Spot FX, Comm...

Citifocus Ltd: ACA - Financial Reporting

£Attractive Package: Citifocus Ltd: Chartered accountant (ACA or CPA), must be...

Ampersand Consulting LLP: UI Designer/ User Interface Designer (UI, User Flow, Design)

£6000 - £60000 per annum + Bonus and Benefits: Ampersand Consulting LLP: UI De...

SThree: The benefits of Recruitment at SThree...

£18000 - £23000 per annum + Comission: SThree: SThree, International Recruitme...

Day In a Page

Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

It's in all our interests to look after servicemen and women who fall on hard times, say party leaders
Millionaire Sol Campbell wades into wealthy backlash against Labour's mansion tax

Sol Campbell cries foul at Labour's mansion tax

The former England defender joins Myleene Klass, Griff Rhys Jones and Melvyn Bragg in criticising proposals
Nicolas Sarkozy returns: The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?

Sarkozy returns

The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?
Is the criticism of Ed Miliband a coded form of anti-Semitism?

Is the criticism of Miliband anti-Semitic?

Attacks on the Labour leader have coalesced around a sense that he is different, weird, a man apart. But is the criticism more sinister?
Ouija boards are the must-have gift this Christmas, fuelled by a schlock horror film

Ouija boards are the must-have festive gift

Simon Usborne explores the appeal - and mysteries - of a century-old parlour game
There's a Good Girl exhibition: How female creatives are changing the way women are portrayed in advertising

In pictures: There's a Good Girl exhibition

The new exhibition reveals how female creatives are changing the way women are portrayed in advertising
UK firm Biscuiteers is giving cookies a makeover - from advent calendars to doll's houses

UK firm Biscuiteers is giving cookies a makeover

It worked with cupcakes, doughnuts and macarons so no wonder someone decided to revamp the humble biscuit
Can SkySaga capture the Minecraft magic?

Can SkySaga capture the Minecraft magic?

It's no surprise that the building game born in Sweden in 2009 and now played by millions, has imitators keen to construct their own mega money-spinner
The King's School is way ahead of the pack when it comes to using the latest classroom technology

Staying connected: The King's School

The school in Cambridgeshire is ahead of the pack when it comes to using the latest classroom technology. Richard Garner discovers how teachers and pupils stay connected
Christmas 2014: 23 best women's perfumes

Festively fragrant: the best women's perfumes

Give a loved one a luxe fragrance this year or treat yourself to a sensual pick-me-up
Arsenal vs Borussia Dortmund: Alex Oxlade-Chamberlain celebrates century with trademark display of speed and intuition

Arsenal vs Borussia Dortmund

The Ox celebrates century with trademark display of speed and intuition
Billy Joe Saunders vs Chris Eubank Jnr: When two worlds collide

When two worlds collide

Traveller Billy Joe Saunders did not have a pampered public-school upbringing - unlike Saturday’s opponent Chris Eubank Jnr
Homeless Veterans Christmas Appeal: Drifting and forgotten - turning lives around for ex-soldiers

Homeless Veterans Christmas Appeal: Turning lives around for ex-soldiers

Our partner charities help veterans on the brink – and get them back on their feet
Putin’s far-right ambition: Think-tank reveals how Russian President is wooing – and funding – populist parties across Europe to gain influence in the EU

Putin’s far-right ambition

Think-tank reveals how Russian President is wooing – and funding – populist parties across Europe to gain influence in the EU
Tove Jansson's Moominland: What was the inspiration for Finland's most famous family?

Escape to Moominland

What was the inspiration for Finland's most famous family?