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The crisis made simple: how dodgy home loans in America led to collapsing banks, falling markets and the end of HBOS
What caused these problems?
It began in America where lenders offered mortgages to people who struggled to meet the repayments, the so-called “sub-prime” loans. The mortgages were pooled and trading in these bundles of loans became an industry in itself. When the US housing market bubble burst last year they fell in value and the losses spread throughout the financial sector.
If the problem started a year ago, why is it taking so long to work itself out?
Only in the past few months has the magnitude of the losses become apparent. It is not simply the banks who lent the money to sub-prime borrowers that have run into trouble. It has also proved incredibly difficult to work out the losses of those who found themselves holding the bundles of loans. And others still have been hit by trading in derivatives based on the value of these loans.
Hang on, what are derivatives?
At their simplest, they are contracts that allow someone to agree a price today at which they can buy or sell something in the future. But the financial markets now trade in some derivatives that are fiendishly complicated - so complicated that it is hard to pin down their true value. The sums involved are huge. For example, the global market in credit default swaps - an insurance-based derivative - is estimated to be worth $45 trillion, or more than twice the value of the US stock market.
What was the trigger for last week's mayhem?
Lehman Brothers, America’s fourth-largest investment bank, went bust last weekend. It had lost almost $14 billion on sub-prime property loans and the fear that it was facing further unquantified losses meant that fellow banks would not lend it any money.
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Investment banks do not hold substantial cash deposits from customers, so without such a flow of money they are doomed.
Similar fears saw Merrill Lynch, another investment bank, ushered into the arms of Bank of America on Monday morning. And the US government was then forced to bail out AIG, the insurance giant, effectively nationalising it in return for an $85 billion loan.
How did this affect HBOS? T
The fact that Lehman had been allowed to collapse showed that the authorities were prepared to let a bank go under. In Britain, HBOS was seen as being vulnerable because it needs to borrow about £200 billion from other banks in order to cover the gap between what its depositors have put in and the amount it has lent out to borrowers. After the Lehman collapse, banks became extremely reluctant to lend to one another. HBOS’s share price collapsed. Lloyds TSB spotted an opportunity and bought its rival at a knockdown price.
Could a big bank be allowed to fail?
No. The collapse of a big bank - on either side of the Atlantic - would have a huge knock-on effect throughout the financial system and the wider economy. No government would allow it to happen.
There has been a lot of talk about short-selling. What is it?
It is a way of trying to profit from a fall in a share price. Short-sellers borrow shares from someone who owns them in exchange for a small fee. The shares are then sold. The short-seller later buys back the shares to return to the original owner. If the price has fallen in the meantime, the short-seller can pocket the difference between the price at which the shares were sold and the price at which they were bought back. So if he borrows and sells the shares when their price is £10 per share and buys them to return them to their owner when it is £5, he makes a £5 profit per share.
What effect does that have?
If there are lots of people selling short at the same time, then the price of the shares will go down because they are being dumped on the market. It can hasten a share price fall.
Who is to blame for the demise of HBOS?
The focus has been on short-sellers who targeted the bank’s shares, helping to create a mood of panic and threatening to provoke a run on HBOS as happened with Northern Rock last year. The evidence, however, suggests that the problem was more that investors had lost confidence in the future of the bank and were selling its shares in great numbers. As far as the bigger picture goes, do not forget that no government tried to rein in the explosion of cheap credit when times were good. Banks were happy to take advantage. But they were also prepared to invest customers’ money in instruments that even their bosses did not understand.
What is the US government doing now?
It seems determined to stop the contagion spreading. Taking over AIG signalled that. Then on Friday it unveiled a scheme that would allow banks to offload their dodgiest loans onto the government in a “bad bank”. The administration hopes that will restore confidence and allow trading in other, more solid debt. Taxpayers could, however, end up having to pay for it all. A similar scheme in the late 1980s saw them hit with a bill for nearly $300 billion at today’s prices.
What happens now?
No doubt other banks will run into trouble when they realise the size of their potential liabilities. However, none of significance will go bust. And given that governments around the globe seem determined to prop up the financial system, the prospect of a complete meltdown is receding. But that does not mean that economic growth will not be dented as lending is reined in. The full effects have yet to be felt beyond the City and Wall Street.
What caused these problems?
It began in America where lenders offered mortgages to people who struggled to meet the repayments, the so-called “sub-prime” loans. The mortgages were pooled and trading in these bundles of loans became an industry in itself. When the US housing market bubble burst last year they fell in value and the losses spread throughout the financial sector.
If the problem started a year ago, why is it taking so long to work itself out?
Only in the past few months has the magnitude of the losses become apparent. It is not simply the banks who lent the money to sub-prime borrowers that have run into trouble. It has also proved incredibly difficult to work out the losses of those who found themselves holding the bundles of loans. And others still have been hit by trading in derivatives based on the value of these loans.
Hang on, what are derivatives?
At their simplest, they are contracts that allow someone to agree a price today at which they can buy or sell something in the future. But the financial markets now trade in some derivatives that are fiendishly complicated - so complicated that it is hard to pin down their true value. The sums involved are huge. For example, the global market in credit default swaps - an insurance-based derivative - is estimated to be worth $45 trillion, or more than twice the value of the US stock market.
What was the trigger for last week's mayhem?
Lehman Brothers, America’s fourth-largest investment bank, went bust last weekend. It had lost almost $14 billion on sub-prime property loans and the fear that it was facing further unquantified losses meant that fellow banks would not lend it any money.
Related Links
Investment banks do not hold substantial cash deposits from customers, so without such a flow of money they are doomed.
Similar fears saw Merrill Lynch, another investment bank, ushered into the arms of Bank of America on Monday morning. And the US government was then forced to bail out AIG, the insurance giant, effectively nationalising it in return for an $85 billion loan.
How did this affect HBOS? T
The fact that Lehman had been allowed to collapse showed that the authorities were prepared to let a bank go under. In Britain, HBOS was seen as being vulnerable because it needs to borrow about £200 billion from other banks in order to cover the gap between what its depositors have put in and the amount it has lent out to borrowers. After the Lehman collapse, banks became extremely reluctant to lend to one another. HBOS’s share price collapsed. Lloyds TSB spotted an opportunity and bought its rival at a knockdown price.
Could a big bank be allowed to fail?
No. The collapse of a big bank - on either side of the Atlantic - would have a huge knock-on effect throughout the financial system and the wider economy. No government would allow it to happen.
There has been a lot of talk about short-selling. What is it?
It is a way of trying to profit from a fall in a share price. Short-sellers borrow shares from someone who owns them in exchange for a small fee. The shares are then sold. The short-seller later buys back the shares to return to the original owner. If the price has fallen in the meantime, the short-seller can pocket the difference between the price at which the shares were sold and the price at which they were bought back. So if he borrows and sells the shares when their price is £10 per share and buys them to return them to their owner when it is £5, he makes a £5 profit per share.
What effect does that have?
If there are lots of people selling short at the same time, then the price of the shares will go down because they are being dumped on the market. It can hasten a share price fall.
Who is to blame for the demise of HBOS?
The focus has been on short-sellers who targeted the bank’s shares, helping to create a mood of panic and threatening to provoke a run on HBOS as happened with Northern Rock last year. The evidence, however, suggests that the problem was more that investors had lost confidence in the future of the bank and were selling its shares in great numbers. As far as the bigger picture goes, do not forget that no government tried to rein in the explosion of cheap credit when times were good. Banks were happy to take advantage. But they were also prepared to invest customers’ money in instruments that even their bosses did not understand.
What is the US government doing now?
It seems determined to stop the contagion spreading. Taking over AIG signalled that. Then on Friday it unveiled a scheme that would allow banks to offload their dodgiest loans onto the government in a “bad bank”. The administration hopes that will restore confidence and allow trading in other, more solid debt. Taxpayers could, however, end up having to pay for it all. A similar scheme in the late 1980s saw them hit with a bill for nearly $300 billion at today’s prices.
What happens now?
No doubt other banks will run into trouble when they realise the size of their potential liabilities. However, none of significance will go bust. And given that governments around the globe seem determined to prop up the financial system, the prospect of a complete meltdown is receding. But that does not mean that economic growth will not be dented as lending is reined in. The full effects have yet to be felt beyond the City and Wall Street.