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Anatomy of a disaster

Kevin Chinnery | Nov. 27, 2008
Who is to blame for the financial crisis?

The credit crunch began on August 9, 2007, on the other side of the Atlantic in Paris. French bank BNP Paribas froze two of its investor funds holding US sub-prime bonds, saying they were unsaleable and therefore could not be valued.

As the implications for bank finances of a souring of such widespread "assets" started sinking in, the European Central Bank pumped $US150 billion into money markets to pre-empt a sharp rise in lending costs as banks took fright. The US Federal Reserve followed suit, but failed to quell rising panic over securitised bonds and other derivatives.

The problem: banks did not know - and still don't - who was holding dubious and still little-understood mortgage derivatives and other bad bonds and loans. This is known as "counter-party risk" - the fear that the other institutions they trade with cannot pay up. Banks would only lend money into the wholesale interbank credit market - essential to keeping the whole credit system working - at exorbitant rates to protect themselves.

It was this loss of basic trust, and the rising cost of using the credit system, which intensified until it came to a head in the debacles of September and October this year. Risk, in bank jargon, was being "repriced" upwards, with a vengeance.

Investors fled first from banks' off-balance-sheet "special investment vehicles", forcing the banks to take their dubious debt assets onto their own balance sheets, further restricting their ability to borrow or lend.

The investment banks were next to be hit. Deliberately kept lightly regulated, they had borrowed up big to lend and invest compared with the amount of equity capital they actually held. They became too thinly capitalised to carry their own debt loads. Banks, investment banks and other debt-based companies that could no longer raise new capital started the huge process of "de-leveraging": reversing debt exposure by either writing off troubled debt assets, trying to sell them, or just hoarding capital - and starving other investors of the means to buy assets for sale.

In October last year, UBS and Citibank led the world's banks in announcing what would quickly become write-offs of $US500 billion in worthless or unsaleable mortgage debt instruments. The chief executives of UBS, Citi and Merrill Lynch were all forced to resign.

The situation proved worst for banks selling debts, bonds and derivatives as the loans they bought them with became due - or, in the case of hedge funds, investors wanted their money back.

The debt instruments were valued on a so-called "mark-to-market" basis: lucrative when markets were rising daily, and disastrous when they were collapsing. The market for these instruments became "illiquid": prices collapsed as the market disappeared, with buyers too spooked and unable to borrow to buy. This fire sale intensified as each quarterly bank reporting period came around. This hit the liquidity of the banks - and their ability to find ready cash to meet their debts. But asset write-offs and losses, plus months of crumbling share prices had also undermined their capital bases. The issue was no longer just liquidity or ready money - it was the solvency of dozens of banks.

 

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