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Credit risks in financial markets

| November 11, 2012 | 0 Comments

Signs of trouble started to multiply early in 2007.On February 22; HSBC fired the head of its U.S mortgage lending business, recognizing losses reaching $10.8 billion. On March 9, DR Horton, the biggest homebuilder, warned of losses from subprime mortgages. On March 12, New Century Financial, one of the biggest subprime lenders, had its shares suspended from trading amid fears that the company was headed for bankruptcy. On March 13, it was reported that late payments on mortgages and home foreclosures rose to new highs. On March 16, Accredited Home Lenders Holding put up $2.7 billion of its subprime loan book for sale at a heavy discount to generate cash for business operations. On April 2, New Century Financial filed for Chapter 11 bankruptcy protection after it was forced to repurchase billions of dollars worth of bad loans.

On June 15, 2007, Bear Stearns announced that two large mortgage hedge funds were having trouble meeting margin calls. Bear grudgingly created a $3.2 billion credit line to bail out one fund and let the other collapse. Investors` equity of $1.5 billion was mostly wiped out.

As late as July 2007, Bernanke still estimated subprime losses at only about $100 billion. When Merrill Lynch and Citigroup took big write-down on in-house collateralized debt obligations, the markets actually staged a relief rally. The S&P 500 hit a new high in mid-July.

It was only at the beginning of August that financial markets really took fright. It came as a shock when Bear Stearns filed for bankruptcy protection for two hedge funds exposed to subprime loans and stopped clients from withdrawing cash from a third fund. As mentioned, Bear Stearns had tried to save these entities by providing $3.2 billion of additional funding.

Liquidity risks in financial markets

Once the crisis erupted, financial markets unraveled with remarkable rapidity. Everything that could go wrong did. Investment banks carried large positions of CDOs off balance sheet in so-called structured investment vehicles (SIVs). The SIVs financed their positions by issuing asset backed commercial paper. As the value of CDOs came into question, the asset-backed commercial paper market dried up, and the investment banks were forced to bail out their SIVs. Most investment banks took the SIVs into their balance sheet and were forced to recognize large losses in the process. Investment banks were also sitting on large loan commitments to finance leveraged buyouts. In the normal course of events, they would package these loans as collateralized loan obligations (CLOs) and sell them off, but the CLO market came to a standstill together with the CDO market, and the banks were left holding a bag worth about $250 billion. Some banks allowed their SIVs to go bust, and some reneged on their leveraged buyout obligations.

This, together with the size of the losses incurred by the banks, served to unnerve the stock market, and price movements became chaotic. So-called market-neutral hedge funds, which exploit small discrepancies in market prices by using very high leverage, ceased to be market neutral and incurred unusual losses. A few highly leveraged ones were wiped out, damaging the reputation of their sponsors and unleashing lawsuits.

All this put tremendous pressure on the banking system. Banks had to put additional items on their balance sheets at a time when their capital base was impaired by unexpected losses. Banks had difficulty assessing their exposure and even greater difficulties estimating the exposure of their counterparts. Consequently, they were reluctant to lend to each other and eager to hoard their liquidity. At first, central banks found it difficult to inject enough liquidity because commercial banks avoided using any of the facilities which had an onus attached to them, and they were also reluctant to deal with each other, but eventually these obstacles were overcome .After all, if there is one thing central banks know how to do, that is to provide liquidity. Only the Bank of England suffered a major debacle when it attempted to rescue Northern Rock, an overextended mortgage lender. Its rescue effort resulted in a run on the bank. Eventually Northern Rock was nationalized and its obligations added to the national debt, pushing the United Kingdom beyond the limits imposed by the Maastricht Treaty.

Extreme uncertainty and volatility in financial markets

Although liquidity had been provided, the crisis refused to abate. Credit spreads continued to widen. Almost all the major banks—Citigroup, Merrill Lynch, Lehman Brothers, Bank of America, Wachovia, UBS, Credit Suisse—announced major write-downs in the fourth quarter, and most have signaled continued write-downs in the fourth quarter, and most have signaled continued write-downs in 2008. Both AIG and Credit Suisse made preliminary fourth-quarter write-down announcements that they repeatedly revised, conveying the doubtless accurate impression that they had lost control of their balance sheets. A $7.2 billion trading fiasco at Societe Generale announced in January 2008, coincided with a selling climax in the stock market and an extraordinary 75 basis point cut in the federal funds rate eight days before the regularly scheduled meeting, when the rate was cut a further 50 basis points. This was unprecedented.

Distress spread from residential real estate to credit card debt, auto debt, and commercial real estate. Trouble at the monocline insurance companies, which traditionally specialized in municipal bonds but ventured into insuring structured and synthetic products, caused the municipal bond market to be disrupted. An even larger unresolved problem is looming in the credit default swaps market.

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Category: Finance, Free Essays

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