Immune? Don't Bank On It

Immune? Don't Bank On It

Sun Herald

Sunday October 5, 2008

Nicole Pedersen McKinnon

Why the subprime crisis is everyone's problem.

"WHAT'S subprime?" I heard a man ask his friend as they walked down a street in town last week.

"It's a loan they gave to lots of people in America who couldn't afford the repayments," the friend said. "Basically, it's a crap loan."

"So what's a bunch of crap loans over the other side of the world got to do with us?"

It's a question that has no doubt been asked by thousands of people around the country last week as the subprime mortgage mess caused our sharemarket - along with markets around the world - to go berserk.

So let's do a little Credit Crisis 101.

"Crap" is probably an appropriate, if inelegant, word to describe subprime mortgages. These loans were issued at rock-bottom interest rates - often to people without a deposit and with very low incomes - that ratcheted up dramatically in subsequent years.

Why would any sensible lender agree to a loan that stood such a high chance of going into default?

Because property was booming and there was an expectation the borrower could use the equity that would build up in the honeymoon period to refinance.

Oh, and because lenders could package up these loans and sell them to institutional investors as funky new financial instruments so it was no skin off their nose if borrowers defaulted anyway.

Except the US Federal Reserve started raising interest rates, so the leap in borrowers' repayments was even more than originally it would have been. Property prices started to fall. And people started defaulting in droves.

The thing is, thanks to the "genius" of the investment bankers who dreamed up the funky financial instruments, institutions across the globe were exposed to these defaults: from a school in the US mid-west to a local council in a German backwater, a swag of local Australian councils and some of our biggest banks.

Worse still, a bit of accounting wizardry meant no one knew which companies had this so-called toxic debt on their balance sheets and might therefore be in danger of collapse.

So institutions became reluctant to lend to each other unless at vastly higher interest rates - the reason we have seen mortgage rates move higher than the Reserve Bank intended.

Slowly but surely over the past few months it has become only too clear just how widespread is the subprime exposure, and just how critical is the funding situation for companies that rely on borrowings to keep afloat. As the number of corporate collapses and fire sales of big-name financial firms has increased, the invisible money flow that underpins our entire financial system has virtually dried up.

And that's what sent our sharemarket reeling last week.

There is much speculation about where this mess will ultimately leave us. A doomsday, pre-$US700 billion ($901 billion) bail-out scenario was widespread unemployment as the world was gripped by a depression.

The worst-case scenario is probably a global recession and a big jump in the difficulty and cost of getting credit - for households, mortgages, personal loans and charge cards. But hopefully it won't come to that.

In any case, the bail-out was designed to stop the credit crisis moving from Wall Street to Main Street. But judging by the conversation I overheard last week, on an awareness level at least it's getting awfully close.

See our cover story for the time line of the crisis - and your disaster recovery plan (page 6). And turn to David Koch's and Penny Pryor's columns for further analysis (pages 4 and 5).