FINANCIAL SECTOR

The Current Economic Environment

The Current Economic Environment

First section

Introduction

The global credit crunch, which began with the drying up of wholesale credit markets, has proved traumatic for the international financial system as many institutions have reported huge write downs in asset values and some have been pushed into forced sale to prevent bankruptcy. Since the US sub-prime problems began to bite in August 2007, one major US institution - Lehman Brothers - has gone bankrupt, and other key mortgage providers in both the USA (Fannie Mae and Freddie Mac) and UK (Northern Rock and Bradford and Bingley) have become dependent upon central government support for their survival. In addition, a number of other institutions have survived only through an arranged take-over.

The credit crunch and bank crises

The credit crunch began in summer 2007, when accumulating losses on US sub-prime mortgages triggered widespread disruption to the global financial system. The problems originated in the growing practice by banks and other mortgage providers of using special purpose entities or collateralised mortgage obligations (CMOs) to “slice and dice” their credit risk exposures. For non housing loans, collateralised debt obligations (CDOs) provided similar opportunities for institutions to pass on their risks via the sale of special bond issues.

A key factor in the crunch is illiquidity in the market for sub-prime mortgage based CMOs due to increasing uncertainty about the value of the underlying collateral. The value of a bond purchased from a CDO or CMO is usually model based, and dependent upon a set of assumptions about the risk of the underlying collateral, but such assumptions are both subjective and uncertain. Most importantly, the perceived risk at the time of purchase of such bonds may change over time, leading to a change in their value.

Commenting on stock market reaction to the collapse of Lehman Brothers, Simon Pilkington, a bank analyst at Cazenove, warned that the forced sale of assets by the liquidator of Lehman would drive write-offs by other banks:

We expect additional valuation write-downs from all the UK banks and particularly Barclays, Royal Bank of Scotland and HBOS. The size of write-downs is unknown at this stage. We are particularly cautious on HBOS, given its exposures and funding structures (Lindsay, 2008).

An additional development in response to the accounting impact of the credit crunch has been a series of class action law suits in the USA against institutions involved in trading, issuing and underwriting CDOs. Cases have already been filed against Citigroup and Merrill Lynch arguing that investors were inadequately informed about their exposure to risks in these markets, and a number of local councils in Australia were threatening to sue a subsidiary of Lehman Brothers over the sale of CDOs (McDermid, 2007), but the bank's demise has made such an action close to worthless.

Rating agencies have also come under fire from both politicians and investors for their role in generating supposedly inaccurate risk classifications for such securities (Graybow, 2008). Additionally, by late 2007 the Securities and Exchange Commission in the USA were conducting more than ...