Friday, February 22, 2008

Credit Crisis – Events and Responses - A Simple Review

Root cause –

  • Slowdown in the housing market in response to rising interest rates. Short rates plateau in the second half of 2006.

Reaction in financial markets –

  • Credit problems with CBO market for subprime lending as a result of rising rates. The rising rates caused an increase in delinquencies and defaults which stressed deal structures. Price of CBO deals decline . No buyers for lower rated tranches.
  • Buyers in SIV ABS market dry up. Funding problems for leveraged deals. SIV ABS market contracts as market moves to Treasuries. Loans placed back on bank balance sheet. Credit crunch in structured market.
  • Losses reported by major financial institutions. Cleaning of executive suites. Risk premiums in LIBOR market increase. Capital infusion for some large institutions to offset losses. Funding risk for financial institutions associated with lack of transparency. Uncertainty with loses from subprime because holders of securities are unknown. Pricing is difficult because no two way markets.
  • Credit standards increased by banks. Lending constrained. Bank loan syndication markets contracts. High yield risk increases as defaults increase.
  • Auction rate municipal market contracts and borrowing rates increase.
  • Monoline insurance provides in crisis which affects municipal market. Bail-out likely. Northern Rock, mortgage lender, is taken over by the British government.

Reaction by the government -

  • Discount rate cut
  • Fed Funds cut to lower the cost of borrowing
  • Term Auction fund to provide credit to banks
  • Some central banks cut funds rate.
  • “Hope Now” program from Treasury Department

Issue –

  • Too little too late?
  • What alternative to cutting rates?

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