Ausgabe 33/2007

US Subprime Crisis Bailing Out the World's Banks

The US subprime mortgage crisis has hit banks and stock markets worldwide, revealing just how fragile the money network is. The European Central Bank has just announced its third cash injection into money markets since Thursday. But is it enough to restore business as usual?

By Beat Balzli, and

The American real estate crisis has sent shock waves through the world's stock markets.

The American real estate crisis has sent shock waves through the world's stock markets.

The presidents of the world's central banks, be it in the United States, Asia or Europe, have their own language. It allows them to talk a lot without actually saying much, and for good reason: Anything that goes beyond empty phrases could trigger an earthquake on the world's securities markets.

Last Thursday, when the first shock waves of the American real estate crisis had just reached Germany and mid-sized bank IKB had just been saved from collapse with a big financial infusion, Jean-Claude Trichet, president of the European Central Bank (ECB) was already talking about a "normalization" and urging investors to keep their cool. The fact that he was calling for calm was enough in itself to make investors nervous.

But on Wednesday of last week, even Trichet was having trouble keeping his composure. The financial bailout he launched was bigger than anything the world has seen since the terrorist attacks of Sept. 11, 2001.

The ECB's cash infusion provided banks with close to €95 billion at 4 percent interest on Thursday. That was followed up with another €61 billion cash injection on Friday, and a third injection of €47.67 billion on Monday. Other central banks around the world, including the US Federal Reserve under its chairman Ben Bernanke, have followed suit with their own cash injections, with Japan's central bank injecting 600 billion yen (€3.6 billion) into money markets Monday.

The liquidity the ECB was offering banks was even more than it had made available after Sept. 11. But instead of allaying fears, this concerted action on the part of international high finance only caused additional nervousness on the markets.

What's wrong with the world's financial markets? Why is cash, supposedly available in abundance for years, suddenly scarce? And how can it be that mortgages issued to borrowers with poor credit in the United States could trigger such a strong reaction in Europe and even Asia?

Stock prices slipped across the board in Tokyo, New York and Frankfurt. Everyone was nervous, from bank executives, regulators and central bankers to ordinary investors who had invested their savings in a supposedly safe money market fund, only to find that it too had invested some of its assets in the US real estate market.

Rumors were enough to throw the financial world into turmoil. Germany's WestLB was on the brink of bankruptcy. The bank, after admitting that it was affected by the problems in the US, was quick to add that its exposure was limited.

But how reliable are such statements? IKB had claimed shortly before its near-collapse that everything was going swimmingly. BaFin, the German federal agency that regulates the financial services industry, is already investigating the German bank Sachsen LB, which invests indirectly in the US real estate market. The crisis even prompted Deutsche Postbank to redirect several hundred million euros of its funds.

There's a shudder of fright running through the executive corridors of the big banks. This led to a serious shortage of liquidity last week, prompting the ECB and other central banks to take swift action.

Stock market prices have slumped in recent days.

Stock market prices have slumped in recent days.

The alarm signals were coming from the money market, the vast currency bazaar where banks provide each other with the liquidity they need to keep their day-to-day operations afloat, and where some banks do the lending while others borrow overnight. The system has been in place for years.

The money market is the heart of the financial world, essentially providing it with its blood flow. But last week it was threatened, for the first time in a long while, by the possibility of heart failure. Analysts speculated that failures among European banks could be the consequence of a crisis on the US mortgage lending market. Professionals in money market departments became nervous. Could they still trust their counterparts at competing institutions? Or was it possible that they would be unable to repay the funds they were borrowing?

This uncertainty prompted a jump in interest rates, threatening to bring the lending business among banks to a standstill. To prevent this from happening, the ECB pumped several billions into the market's principal arteries.

Although alert central banks can prevent the money cycle from collapsing, they have no power to correct the true causes of the turbulence. These causes go back a number of years, and they depend primarily on the fact that money, from a global perspective, seemed abundantly available and, as a result, was cheap.

After Sept. 11, 2001, then US Federal Reserve Chairman Alan Greenspan kept interest rates low to boost the economy and keep it growing. In addition, pension funds, fat with their investors' billions, were looking for investment opportunities. The banks, for their part, had developed a new method that allowed them to loosen their lending requirements while keeping the attendant risks off their books.

They did this by bundling the loans they had issued to various customers and selling them as packages. Funds acquired them, put together their own packages and then sold them to other investors. The banks argued that this would distribute the risks of the global financial system more broadly. If a major borrower went belly-up it would no longer affect the lender as seriously as before.

This is one of the advantages of the system. But it also has a serious drawback.

Banks are tempted to issue much riskier loans, not just to US mortgage borrowers unable to provide sufficient collateral, but also to private equity firms with little equity capital of their own seeking to take over other companies in leveraged buyouts.


© DER SPIEGEL 33/2007
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