Financial Market

 With the world market feeling the effects of the global credit crunch, Financial Market takes a look at how a booming 2004 economy deteriorated as it was hit by the sub prime mortgage crisis.

Wall Street is the very epicentre of the world financial system, a place where bankers and economists decide who to lend money to and how to make money in doing so. In 2004 the economy was strong, business was booming and low interest rates meant borrowing money was about as cheap as it had ever been. Coupled with this there was the demand for borrowing which was soaring.

At this time the US economy was strong, and banks were in a position where they were accepting applications for money from applicants who would have otherwise been turned down in the past.

This low interest rate was also seen in the Euro zone and UK, reflecting a positive economies that were not just state side. House prices were going up, inflation was low and banks outside the US felt confident in lending too.

In 2005 there were changes to the world financial system. Interest rate rises meant that some sub-prime loans started to fail, and people who borrowed couldn’t afford to pay the banks back. On the back of this banks went to books to access how much equity was tied up in sub-prime loans in order to evaluate the risk and their potential losses. The money tied up in sub-prime loans however wasn’t so easy to calculate due to securitisation.

Securitisation is the creation of asset backed finances, debt securities that are backed by a stream of cash flows. In essence the conversion of an asset into a marketable security.

In terms of sub-prime loans securitisation is the process of banks packaging loans together in order to sell them on the market. An investment is then backed by cash flow or the value of the underlying asset, typically real estate. As the original sub-prime loan is at this point mixed with other debts, it is hard to see the exact figure of sub-prime specific cash that was at risk.

With the international nature of the financial market system these liquid assets had been sold across the world, with a percentage of the sub-prime debt residing up in UK. What originally had looked like a US problems turned out to have global consequences.

At this point in time there was an air of panic around and subsequently there was a break put on lending until the full potential cost of the crisis could be calculated. In summer 2007 inter-bank lending effectively dried up over night and the fifth largest UK lender Northern Rock was forced to ask the Bank of England for financial support.

Central banks responded by cutting interest rates with the aim of restoring confidence in borrowing amid fears that the knock on economic consequences would be far worse.

Soon to follow were numerous high profile institutions revealing billions of dollars of losses after one another, resulting in market fears leaping a potential slowing down of the US economy to the very real threat of recession, a situation the current financial market system finds itself in today.