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Monetary and capital markets

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Sub−prime mortgage crisis holds market attention

Wed, Oct 24 2007, 12:34 GMT
by La Caixa Economic Research Dept.

La Caixa

September brought a continuation of the sub-prime mortgage crisis in the United States and its impact on the rest of the world through the financial markets.

 Secretary of the Treasury Henry Paulson declared that the crisis would be a long one. The European Commissioner for Economic and Financial Affairs, Joaquín Almunia joined in this view when stating that the volatility of the markets was behind the decision to lower the forecasts for economic growth. That is to say, he recognized that the spread of the damage in the financial markets to the real economy was indeed a fact. The interbank market in the United States continued to rise, as may be seen in the following graph, while the state of liquidity was being maintained. While investors took refuge in government securities, buying US Treasury bills, the banks reduced their positions in the interbank market and had difficulty in issuing bonds. In the United States, for example, the outstanding balance of notes with real security in the private fixed-income market dropped by 251.3 billion dollars in just a few weeks. On June 25 there was an outstanding balance of 1,180 billion dollars, whereas by September 19 this had been reduced to 930 billion dollars.

 That is to say, this was paper issued by various companies that fell due and could not be refinanced in the markets because they were excessively expensive because of widening of loan differentials. Another example of the problems brought about by the mortgage crisis was the pattern followed by the British bank Northern Rock. On September 13 it announced that it had asked for emergency funds from the Bank of England as lender of last resort with the agreement of the UK Chancellor of the Exchequer for an amount of 3 billion pounds sterling (4.38 billion euros). The reason for the move was the difficulty in obtaining funds in the interbank market given that the bank was financing more than 75% of its loan operations through that market instead of through deposits.

 After making this announcement, the bank’s shares collapsed by 32%. In 2000, Northern Rock became part of the FTSE 100 stock exchange index which includes the 100 companies with highest capitalization listed on the London stock exchange. In spite of having few branches, the notable impact of its liquidity crisis in the financial system was due to its strong development of financial innovation which allowed it to shift risk very rapidly. On September 14, the day after the announcement, there were long line-ups of customers wanting to withdraw all their savings. In two days the bank had lost 2 billion pounds sterling. On September 17, the share price again plummeted by 35% going from 438 pennies to 283 pennies. That day, the Chancellor of the Exchequer announced that the British government and the Bank of England would guarantee all the deposits of Northern Rock without any limit.

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Published on  Wed, Oct 24 2007, 12:42 GMT