While stock markets around the world breathed a collective sigh of relief after the Bush administration announced the largest economic bailout of all time it seems as though many investors may have jumped the gun a little. Even though it seems inevitable that the deal will be rubber stamped by Congress in the near future there are concerns that political infighting and a lack of detail may scupper the deal in the short term – or at least force the Treasury and Federal Bank back to the drawing board.
After the fall of Lehman Brothers it became apparent just how much trouble had been stored up in the US economy over the past decade of unbridled joy in the
property and stock markets of the country. Investors had been making money hand over fist, the banks had more business than they could cope with but competition was growing. It was ultimately this competition which was to herald the spectacular downfall of the US economy at a speed which many thought impossible.
Background to the rescue package
The last decade has seen more US citizens join the property boom and the stock market party than ever before with many making good money. However, the higher markets went the more people were concerned they were missing out, investing their funds on high valuations and high multiples, leaving very little room for error.
Despite a number of warnings a full 12 months before the credit crunch hit home in the US, investors and traders were happy to pump more and more money into the stock market and property markets. As the more traditional property markets became overly competitive and margins shrank, many institutions moved into the sub-prime market which offered higher profit margins but greater risk to capital by lending money to those with sub-prime credit histories. However, surely with the stock market moving higher, property prices on the increase this was money for nothing, a risk free investment?
As the sub-prime markets continued to boom there came a point when the US economy showed definite signs of cooling. Like a seesaw with the sub-prime lenders placed at the furthest edge of the balance, a small downwards movement had a magnified impact on the sub-prime markets. However, while sub-prime mortgages came under pressure the main market was still performing very well and many investors just shrugged their shoulders and ignored the sub-prime problems.
Slowly but surely these problems in the sub-prime market began to mushroom as bearish noises about the US economy started to surface. The signs were there a full 12 months before the markets crashed but investors were on such a high that they saw sell-offs as an opportunity to pump more money into the markets. When the first sub-prime lender failed there was concern but no panic and then suddenly like a pack of cards more and more hit the rocks and then concerns started to filter through to the main mortgage markets. But worse was to come!
In mid-2007 we began to see the impact which the sub-prime crash was having on the asset base of well known and well funded banks around the world. Assuming that the sub-prime mortgage sector was safe many had taken on packaged bonds which consisted of an array of sliced and diced mortgage agreements across the risk spectrum. The more risky bonds – the sub-prime backed investments – offered the highest returns but the highest risks but unfortunately this did not put too many financial institutions off chasing the next buck.
A fall in bank asset backing prompted many to pull back from lending in the money markets and what began as a blip soon turned into the largest credit crunch seen since the great depression in the early 1900s. Institutions could not afford to let any funding go out to third parties overnight but more and more companies needed finance to see them through their traditional operations. Financial Armageddon was upon us and once it began there was very little that could be done to stop it!
Government intervention
As the credit crunch started to spread around the world (the worldwide financial community is very insidious) it soon became apparent that this was not just a US problem and it was like no other situation governments had seen in modern times.
Initially the central banks around the world decided to pump money into the system and reduce interest rates to try and inject some confidence. But confidence was shot to pieces, companies had decided to retain whatever capital they had as a safety net which had the knock on affect of literally closing the international money markets overnight. Governments around the world soon realised that it did not matter how much they reduced interest rates by, this was a crisis of confidence with large institutions discovering massive losses from assets backed by sub-prime mortgage agreements, the chain reaction was about to start!
Toxic Economy?
The sudden demise of the international money markets had a massive knock on affect to all areas of the economy, house prices started to fall as mortgages were refused and many people around the world started to fall into serious financial trouble. So what will the US rescue package do?
The idea behind the package is to buy up literally $700 billion of so called ‘toxic’ investments which have been at the root of the economic crisis – these are the asset linked to the sub-prime markets and described as ‘toxic’ because each collapsing investment has a knock affect to a related investment and so on. This purchase of the ‘toxic’ assets should steady the markets, reduce further falls in these investments and also give the financial institutions increased liquidity with which to try and get there businesses back on track.
However, it is not all give, give, give with the financial institutions who take up this deal being asked to take a 10% hit on their mortgage books in order to take some of the pressure off the housing market and reduce repossessions. Apart from the fact that Congress has not been as accommodating as the authorities had hoped and the deal may be delayed, it now turns out that it is a voluntary arrangement. Will the banks bleed their customers dry before taking up the government’s offer?
For the record there have been 2.7 million homes repossessed in the US over the last 18 months which is more than one year’s supply of new homes to the market – prior to the crash. There is much slack for the sector to pick up when it does recover, so don’t expect an overnight recovery in property prices!