This is from one of the main banks, forwarded to their brokers. I think it is the most concise step by step I've read on the subject...and yes, I know most people here know the basic facts anyway!
The crisis of insecurity and nerves that is afflicting the global banking
system continues to worsen. Two of the world's most powerful banks, Citibank
and Merrill Lynch, have each lost chief executives along with billions of
dollars, losses they failed to anticipate or fully account for.
Share prices of British banks, and their European counterparts continue to
fall in the absence of the information that will put investors minds at
rest. The market for lending between banks, crucial for mortgages and
commercial lending to companies, remains paralysed.
The Bank of England has around 30 billion of taxpayers money tied up
supporting mortgage bank Northern Rock. That bank's new mortgage business
has since dwindled to a fifth of its previous level. The impact the crisis
is still growing and no-one seems to know when or how it will end.
Here is the easy guide: 10 frequently asked questions about the 2007 banking
crisis and answers that will put you firmly in the picture.
1. How did this all start?
Banks in the US have for years been falling over themselves to lend money in
the property boom that has been running from coast to coast. Many of the
loans were made to people who really couldn't afford to meet the repayments,
but were persuaded that now was the time they could get on the housing
Now many of those people can't make their repayments. House prices are
tumbling, homes are being repossessed and around $200 billion of duff loans
are coming home to roost.
2. Why lend to those who can't afford it?
There was a time when banks got their own deposits from savers, judged who
was worth a loan, and lived with the results. If the loan decision was good,
repayments were made and with them came profits. If not, the bank made
losses on the money it couldn't recover.
Not these days. Many banks who made US property loans this time have sold
them on. Instead of bankers, they were more like estate agents, earning a
sales commission. They could afford to overlook a borrower's weak employment
record, the poor state of the home, and many other issues because making
that loan pay in a year or two's time was going to be someone else's
3. Okay, that's in America. Why should it matter to us?
It matters to us because these bad loans have been spread about the world,
like a consignment of bad meat delivered to a global burger chain. Most
banks are sitting with the financial equivalent of tonnes of burgers frozen
in their vaults labelled "mixed financial product, sourced in many places."
Who knows what's actually in them? Almost no-one. You just have to wait to
see who falls ill after consuming them.
These minced financial packages have been through a process called
securitization, by sorting them into grades which could then be traded. Like
supermarket burgers or sausages, some of these mortgage-backed securities
would be sold as premium, in that the expected return on the mortgages was
pretty tasty, some as standard fare, and some as cheap "subprime" in which
there was a fair amount of financial gristle and bone, i.e. bad credit
4. Why did this problem drag others in?
Essentially because of clever packaging. However poor the financial quality
of these products, they were spiced up to look attractive by being turned
into collateralised debt obligations (CDOs). These are like an up-market
financial Christmas hamper, full of a variety of products offering
yummy-sounding returns, but underneath the luxury jam and the Christmas pud,
quite a few of those same dodgy burgers and sausages, neatly repackaged and
These CDOs were very attractive to pension funds and hedge funds, who bought
them in large quantities, helped by ratings agencies (the financial
equivalent of the consumer guide "Which?") that gave some of them a
Agencies like Standard & Poor's and Moody's have since been slated for their
role in assessing the quality of these products.
5. What was hedge funds' role in this?
Once banks discovered that there was something rotten in the mortgage-backed
securities and CDOs they would no longer take these as collateral for other
lending. Hedge funds, buccaneering financial groups dedicated to making
money in good times or bad, had borrowed very heavily against these assets
to fund their trading activities now had to raise money another way.
They couldn't sell their CDOs because no-one really knew what they were
worth, especially once their quality was questioned. Instead they sold
shares, whose values are established by the stock market, an independent
market place. That was when the problem first emerged to a level the
ordinary investor would notice.
6. I've read about off-balance sheet problems. What are they?
Banks are sometimes too clever for their own good. They have for tax and
regulatory reasons created so-called structured investment vehicles, whose
assets and liabilities do not appear on the owning bank's balance sheet.
These are almost like separate companies which issue commercial paper (i.e.
bonds) in their own name, secured against the assets they hold. What were
those assets? Yes, you've guessed it, they included big slabs of
mortgage-backed securities. Many of these SIVs are now in big trouble,
starved of funds and unable to offload their assets.
The upshot is likely to be that banks have to take them back on board their
balance sheets, which will in turn soak up capital which could otherwise be
lent. That in short will crimp the future lending which powers the global
7. I thought this had finished weeks ago!
So did the banks. Merrill Lynch in October set aside savings to cover losses
of $4.5 billion on mortgage-backed securities, and just a few weeks later
upped those provisions to $7.9 billion. That was enough to force the
resignation of Stan O'Neill, the chief executive.
Last week, Meredith Whitney, an analyst at CIBC World Markets predicted that
Citigroup, the world's largest bank, had so much trouble stored up that it
might have to cut its dividend. "We believe over (the) near term, Citigroup
will need to raise over $30 billion in capital through either asset sales, a
dividend cut, a capital raise, or combination thereof," she said.
Citigroup now admits it may have to take $8 billion-$11 billion of losses,
having only posted losses of $3.3 billion when it last reported quarterly
results. The embarrassment is compounded by the fact that it took an
external analyst armed only with a spreadsheet and a sharp brain to tell it
what it should long have known itself.
8. But how did this affect Northern Rock?
Northern Rock just happened to be standing at the end of the line when a
long, long credit rug was pulled away.
Once banks started to get suspicious of each other, they refused to lend in
what is called the inter-bank market. Northern Rock had a much larger
proportion of its funds sourced through these wholesale funds than most of
its rivals, and when the tap was turned off was struggling to repay other
short-term funding that fell due.
The quality of Northern Rock's own lending was as good as any bank in the
UK, but this wasn't really the issue. With only a few branches and a
relatively small base of savers, it hadn't the inflow of money to make fresh
loans until the Bank of England stepped in.
Now, according to intermediaries that re-sell Northern Rock mortgages,
business is running at less than a quarter of the level of earlier in the
year. That puts further pressure on the embattled lender.
9. Does this affect the real economy?
In some ways it already has. Though the US economy is very resilient,
consumer spending and confidence there has already slowed because of the
sub-prime crisis and falling house values.
Though the US Federal Reserve has cut interest rates, which should make many
feel better off, the rates on many new home loans are going up not down.
This is partly because of the end of low introductory interest rates on many
loans, and the general credit tightening for new applicants.
What we have now is a generally inflationary world economy where interest
rates should be higher, but because of fears for the state of the finance
system have been cut artificially low. That is why, even as banks fell,
shares in big commodity companies and the Chinese stock market have been
ripping away. That can only go on so long. By cutting rates now, the chances
of slowing this boom gently have worsened.
10. When will this end?
It can't end until banks unpick the various packages of mortgage-backed
securities whose value determines the CDOs and other securities on their
balance sheets. It is something like a major food recall. You track down
where the contaminated produce began, look at where it was distributed, who
has got it in their cold stores and warehouse, and see into which other
financial sausages it got mixed.
Finally, the whole lot has to be packed up, realistically priced and willing
buyers found. That, it seems certain, is going to take many months yet.