October 2008

Financial markets have survived many shocks throughout their history. In recent months, the story around the volatility in financial markets across the globe has grown in scope and complexity. Market and other economic news seem to be in the headlines more than other national and international events, while investors are bombarded by news on the volatility of the stock markets.

A year ago, few people had heard of the term 'credit crisis', but the phrase has now entered dictionaries and everyday language, and is defined by Investopedia.com as "an economic condition in which investment capital is difficult to obtain". Many Canadian investors are wondering how it originated and the potential impact on their investments. This article outlines the key events that led to, and subsequently accelerated, the credit crisis. In the companion article, The Global Credit Crisis: Reaction v. Reality, we address the gap that sometimes exist between investor reactions to market volatility and the reality of their own portfolio, highlighting the importance of maintaining a historical perspective on market behaviour and a forward focus on your investment plan and portfolio.

The start of the 'credit crisis' phenomenon can be traced to August 2007, when bad news from a French bank, BNP Paribas, triggered a sharp rise in the cost of credit and made the financial world take note of how serious the situation was. The problems, however, started much earlier, and are linked to the sub-prime mortgage business in the U.S., in which banks give high-risk loans to people with poor or no credit histories.

• To lessen the effects of the bursting of the technology 'bubble' in 2000, interest rates in the U.S. were progressively lowered. This made mortgages more affordable, fuelling the growth of the housing market and raising prices.
  
  
• As demand for mortgages rose, their quality declined as those companies offering mortgages sold them to banks, which in turn bundled and re-sold them to other financial institutions globally as 'mortgage-backed securities', which are bonds backed by the mortgage payments of homeowners.
  
  
• Subsequently, between 2004 and 2006, when U.S. interest rates rose from 1% to 5.35%, the U.S. housing market began to suffer, with prices falling and a rise in homeowners – especially those with sub-prime loans – defaulting on their mortgages, making the mortgage-backed securities worthless.
  
  
• By mid-2007, the outfall of the sub-prime mortgage problem had begun to spread, with institutions in the U.S and other countries who had invested in the mortgage-backed securities suffering losses, and being reluctant to take on further debt of this kind. The credit markets began to freeze as banks become reluctant to lend to each other, not knowing how many bad loans could be on their competitors' books.
  
  
• In August 2007, the U.S. Federal Reserve and the European Central Bank tried to bolster the money markets by making funds available for banks to borrow on more favorable terms. Interest rates were also cut in an effort to encourage lending. However, this short-term help did not solve the liquidity crisis, as banks remained cautious about lending to each other. A lack of credit - to banks, companies and individuals – brought with it the threat of recession, job losses, bankruptcies, repossessions and a rise in living costs.
  
  
• In September 2007, U.K. bank Northern Rock sought an emergency loan from the UK government to stay afloat, prompting a "run" on the bank. The bank was subsequently nationalized.
  
  
• Through the remainder of 2007 and into 2008, major losses and write-downs related to sub-prime investments were announced by several leading investment banks in the U.S., Europe and elsewhere, including UBS, Citigroup, and Merrill Lynch.
  
  
• In March 2008, the near-collapse of Wall Street's fifth-largest bank, Bear Stearns, led to a crisis of confidence in the financial sector and the end of investment-only banks. Bear Stearns was acquired by larger rival JP Morgan Chase for $240m in a deal backed by $30bn of central bank loans. A year earlier, Bear Stearns had been worth around $9bn.
  
  
• Through the summer of 2008, many U.S. investment banks, as well as government-sponsored entities, began to accumulate losses and faced significant financial difficulties or bankruptcy. The U.S. Federal Reserve and Treasury, as well as other banks, took over many prominent U.S. financial institutions, including Freddie Mac and Fannie Mae, Lehman Brothers, Merrill Lynch, AIG and Wachovia.
  
  
• Overseas, and particularly in the UK and other continental European countries, the consolidation, recapitalization, or nationalization of several large banks and other financial institutions became increasingly prevalent. Worldwide, there were also significant increases in the amount of personal savings guaranteed by national governments.
  
  
• Seeking a long-term solution to the credit crisis, in early October 2008, after first being rejected, the U.S. government passed a $700 billion bail-out package that aimed to restore confidence and stabilize global financial markets by addressing a number of issues relating to the credit crisis. Primarily, the government plans to buy up Wall Street's bad debts in return for a stake in the banks, and hopes it can sell the distressed assets back once the housing market has stabilized. Similar banking sector bail-out plans have also been announced by many other countries.
  
  
• Recent weeks have also seen many supranational bodies - such as the G7 and G20 groups of nations, World Bank, International Monetary Fund (IMF) and European Union - taking steps to encourage or facilitate coordinated responses across countries to ease the crisis. For example, on October 8, the U.S. Federal Reserve, European Central Bank, Bank of England, and the central banks of Canada, Sweden and Switzerland each made an emergency interest rate cut.