Many of us have been hearing about the great crashes in various stock markets all around the world as a result of some financial follies in the US. I once received an Orkut mail on the detailed, yet simple expanation of this problem. Here is the full extract of the explanation-made-easy of the US subprime mortgage problem.
Q&A: World stock market falls
Stock markets around the world have been falling sharply on fears of a credit crunch that could affect the financial sector. What is causing the fall, and how will it affect the ordinary individual?
What has been happening to the world's stock markets?
The value of the world's major companies has taken a tumble as the world's stock markets have plunged in the past two days - one of several such sharp declines in the past few months. The move has wiped billions of dollars off the value of shares owned by individuals and institutions such as pension funds and insurance companies. This most recent fall started when a French bank, BNP, said it would freeze three investment funds because it could no longer accurately measure their value. Fears that more undisclosed bad debts would surface led other banks to cut back on their everyday lending to one another. That led the European Central Bank to step in and boost the amount of money in the financial system. Markets fell around the world because they were nervous that the problems are not just confined to French banks, but are more widespread in the financial sector.
What are the markets worried about?
The underlying fear relates to the so-called sub-prime mortgage market in the US. In the past five years, extraordinarily low interest rates in the US have led banks and other financial institutions to lend substantial sums of money to people with poor or no credit histories. The idea was that, even if they eventually couldn't pay, the banks could recoup any losses by repossessing and reselling the houses - and in any case, house price rises would cushion the blow. In the most extreme cases, mortgage brokers were handing out what came to be known as "Ninja" loans, to people with no income, no job and no assets. Often the loans were "no-doc", where the borrower did not have to provide proof of how much they earned. Recent research suggests that in many if not most of these, borrowers (or their brokers) lied about their income. But now as interest rates have risen, so have repossessions. The US housing market has collapsed, and the banks find themselves saddled with a lot of bad debts.
However, it is not just a problem for US banks.
Globalisation has meant that much of this mortgage debt has been sliced up into small pieces, repackaged as "collaterised mortgage obligations" and sold on to financial institutions and individual investors around the world. And now, no one, including the central banks, is certain how much of these bad debt financial institutions or individuals are holding.
What is a credit crunch?
There are fears that the worries about bad debts could turn into a financial panic. Because no one knows which banks are sound, investors may rush to withdraw their money from a large number of institutions, which would otherwise be solvent. This so-called liquidity crisis could destabilise the economy: forcing interest rates up sharply, causing some banks to collapse, and preventing lending to legitimate companies who want to invest. It is this fear that the world central banks are trying to address by injecting cash into the system - making it clear that they will not allow major banks to fail just because of a rush on their funds. They took similar action after September 11, 2001, to prevent the terrorist attacks in the US from spreading financial panic around the world.
What are the wider implications?
Even if the central banks stem the financial panic, there seems to have been a general shift in market perceptions about risk. Generally, the risky the investment, the higher the interest rate - but now the additional premium for risky investments (the "spread") is set to widen sharply. When people with money to lend become worried about risks, they tend to put their money in safe investments. So there has been a rush to invest in government bonds, like US Treasury bonds, and safe currencies, like the yen. In contrast, people are now demanding much higher interest rates to lend to smaller companies or to the governments of developing countries. And there is almost no market at the moment for the debt relating to sub-prime mortgages or leveraged buy-outs - corporate takeovers funded by taking on big debt rather than with cash or shares. This may mean that this is much less takeover activity than in the past few years, when it has been mainly funded by private equity funds borrowing money cheaply. That could also lower the value of the stock market in the short-term.
How long will it go on?
Stock market fluctuations are a normal part of stock market activity, and no one can say how far shares could fall or how long the slowdown could persist. Markets have had quite a sharp rise in the past 18 months, and the current correction may simply return them to previous levels. Broadly, company profits have been strong, and the world economy seems to be entering a period of revival, especially in Europe and Japan.
However, stock markets look at future expectations, so they may be concerned that corporate profits have already peaked. And even if stock markets recover, it looks like the re-pricing of risk - making it more expensive to borrow for certain kinds of investments - is here to stay. The world's major central banks, with the exception so far of the US Federal Reserve, look set to continue to raise interest rates to combat inflationary fears - even if they pause to wait until markets calm down.
What does it mean to you?
Many individuals own stocks and shares - about half of all US households, and around a quarter of those in the UK. If the stock market falls continue, they may feel less wealthy - and be less likely to buy goods and services, slowing the economy. In addition, many pension funds own shares which make up part of their portfolio used to pay people's occupational pensions. If shares fall, they may have less money to pay future pensions, and employee contributions may have to rise.
Already in both the UK and US many companies have closed company pension schemes to new employees. Finally, the impact on businesses could be mixed. Smaller, more risky ventures could find it more difficult to get funding, slowing the pace of innovation. But big companies might become less vulnerable to takeovers, which could mean fewer job losses and restructuring costs as long as profits keep up.
Hope this information has proved to be useful to you...