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Anatomy of a disaster

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

The torrent started by the mortgage collapse had eaten through the thin buffers of bank capital faster than any regulator could have imagined.

Black September and worse

The stage was set for Black September - to be followed by an even worse October.

On September 2, the US government-backed mortgage guarantors Freddie Mac and Fannie Mae, with $US5 trillion in home loans, were nationalised following investor panic.

To generate ever more mortgages, regulators had allowed the pair to invest 40 times their capital in mortgages, compared with a ratio of 10 for regular bank balance sheets, leaving them hugely undercapitalised to face the storm. Financial-sector shares were battered as their shareholders were left to carry the losses.

Thirteen days later on September 15, the US government drew the line on more bail-outs, leaving investment bank Lehman Brothers to fail after huge derivative losses. The collapse had a disastrous effect on short-term money market funds that held Lehman debt.

These funds are normally considered safe institutions that lend money into the banking system overnight. For the first time, they were "breaking the buck", failing to return all the dollars invested. Investment of more than $US400 billion fled the money market. The result was another spiral of liquidity crises for banks increasingly reliant on short-term funding as long-term lending dried up.

On the same day, Merrill Lynch raced against collapse to sell itself to Bank of America. Lehman proved to be the turning point of a far deeper crisis.

Bad debts and losses were also battering the value of credit default swaps, used by investors to insure against borrowers going under (and, by some, to bet on them failing).

American International Group, the world's largest insurer, had written huge amounts of insurance on credit default swaps, mortgage securities and other derivatives. Banks also relied on the insurance cover to value the huge volumes of derivatives they still held. If AIG was forced to fold, credit markets would face a terminal blow.

On September 16, AIG was nationalised with a $US85 billion loan. In a measure of the complexity of such derivatives, the group reportedly underestimated its exposure to credit default swaps by a factor of 10. By November, the AIG rescue package had reached $150 billion.

Two days later, the credit crunch turned to credit freeze as the London US dollar overnight interbank rate spiked from 2 per cent to more than 6.5 per cent. Sharemarkets were leaderless and falling as global central banks pumped in $US250 billion to restart credit markets. Investors were suffering the worst crisis of confidence since the Great Crash of 1929 as fears that nothing was safe took hold.

 

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