Cause of the Crisis

The current crisis stems from changes that have been quietly taking root in the west for many years. Half a century ago, banking appeared to be a relatively simple craft. When commercial banks extended loans, they typically kept those on their own books – and they used rudimentary calculations (combined with knowledge of their customers) when deciding whether to lend or not.

From the 1970s onwards, however, two revolutions occurred: banks started to sell their credit risk on to third-party investors in the blossoming capital markets; and they adopted complex computer-based systems for measuring credit risk that were often imported from the hard sciences – and designed by statistical “geeks” such as Mr den Braber at RBS.

Until the summer of 2007, most investors, bankers and policymakers assumed that those revolutions represented real “progress” that was beneficial for the economy as a whole.

Regulators were delighted that banks were shedding credit exposures.....

Bankers were even more thrilled, because when they repackaged loans for sale to outside investors, they garnered fees at almost every stage of the “slicing and dicing” chain.

Moreover, when banks shed credit risk, regulators permitted them to make more loans – enabling more credit to be pumped into the economy, creating even more bank fees.......

When a team at JPMorgan developed credit derivatives in the late 1990s, a favourite buzzword in their market literature was that these derivatives would promote “market completion” – or more perfect free markets. In reality, many of the new products were so specialised that they were never traded in “free” markets at all.

The result was that a set of innovations that were supposed to create freer markets actually produced an opaque world in which risk was being concentrated – and in ways almost nobody understood. By 2006, it could “take a whole weekend” for computers to perform the calculations needed to assess the risks of complex CDOs, admit officials at Standard & Poor’s rating agency.

Most investors were happy to buy products such as CDOs because they trusted the value of credit ratings. ....

In July 2007, this blind faith started to crack....

Gillian Tett in the Business Spectator.

International Financial Crisis

In the second week of September 2008, the international banking system staggered an almost collapsed after Lehman Brothers went into bankruptcy. Bankers and governments managed to keep the system from going under, but four four major problems still haunt the clever people of the world.

1. Sub-prime Crisis
The collapse of the housing bubble has caused enormous problems for banks. This is often referred to as the subprime crisis, but the problem goes far beyond subprime sectors. Defaults have increased among all borrowers and the shocks have spread to financial institutions throughout America and Europe due to the wide spread securitisation of mortgages.

2. Eastern Europe
European banks are heavily exposed in Eastern Europe. They have fund a housing bubble in these countries, but now with house prices falling and their currencies collapsing, many will be unable to repay their loans. Ambrose Evans-Pritchard at the UK Telegraph tends to be overdramatic, but he provides a good description of the problem.

Western banks that have lent $1.74 trillion to the ex-Soviet bloc -- split between $1 trillion in foreign loans and $700bn in local currency debt through subsidiaries,

3. Synthetic CDOs
A huge problem that has not yet surfaced is synthetic CDOs. These complex financial instruments have been clearly described by Alan Kohler at the Business Spectator. He suggests that that $0.5 trillion of these could be out standing. The sting in the tail is that if eight or nine major named financial institution collapse (five or six have already gone), the holders of these securities will lose their money. This might prove to be a worse problem than the subprime debacle.

4. Private Equity
Over the large decade private equity firms undertook a huge number of leveraged buyouts. The private equity model minimises equity and maximise debt. This has left banks with huge exposure to businesses that are declining in value as their profits collapse. These chickens have still no come home to roost, so the banks are uncertain what their liabilities will be. This is one reason why they are holding extra reserves.