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Anatomy of a disaster

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

November 4: RBA cuts another 0.75 per cent to saw 200 basis points off the cash rate in three months. It forecasts 1 per cent growth to June 2009 if rates stay at 5.75 per cent - flagging more rapid cuts as a certainty.

November 6: IMF forecasts first simultaneous recession across developed economies since WWII.

November 9: China announces $855 billion infrastructure spending to help keep it at the 8 per cent annual growth rate that will hold up demand for Australian minerals. At stake: $200 billion in future mineral investment for Australia.

November 15-16: Citigroup shares fall 23 per cent in one day as doubts grow over US government handling of toxic debt bail-out package. ASX/S&P 200 falls 22 per cent in preceding 12 days, completing wipe out of share-boom gains since 2004.

Debt, derivatives and destruction

One thing above all else has made this crisis as nasty as it is: the unravelling of huge trading by banks in derivatives, using borrowed money. The complexity of this collapse spread distrust through the whole credit system and froze its functioning.

This is ironic because derivative products were designed originally to ease the process of lending by spreading out risk.

The most well-known derivative involved in the crisis is the collateralised debt obligation, a kind of bond designed to spread the risk of mortgage lending. CDO originators pool mortgages together, split the bundle by different degrees of risk and, in a process called securitisation, sell those bits on to different investors with a share in the repayment stream. Each underlying mortgage may involve up to five or six or more buyers and sellers of the debt. These investors are all connected to each other if the mortgage defaults, although the chain is hard to keep track of. CDOs were not spreading the risk - they were hiding it.

CDOs had been invented in the 1970s to allow banks to fund mortgages for the bulge of US baby-boomer home buyers without straining bank balance sheets. But post-2000, the long period of low interest rates meant finance houses needed to find new ways to make money. CDOs could turn even the most unstable loans into tradeable assets - duly stamped gold-plated AAA by ratings agencies. The most lucrative market of all was high-interest sub-prime credit marketed to those who would never otherwise qualify to borrow.

US Federal Reserve chairman Alan Greenspan backed the view that derivatives and other financial innovations made an ever-expanding financial system actually safer than before, able to function well with little regulation and with less need for reserve capital. The US Congress passed laws forbidding anyone from regulating derivative trade.

 

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