All About the Bank Bail Out

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All About the Bank Bail Out – Part 1

Published in February 2nd, 2009

The phrase “credit crunch” has been firmly etched into the history books thanks to the countless media stories circulating around the globe over the past few years. The phrase has been coined to summarise into a few words the massive problems with the banking system throughout the developed world. While the term has been used to label many events and circumstances engulfing the world, in essence it involves banks being unwilling to lend money. The credit market has crunched and it is proving difficult to fix.

At the root of the problem are sub-prime mortgages. These mortgages are loans that were lent to borrowers of questionable ability to repay the balance and the interest charged. The loans were secured against residential properties throughout the developed world, particularly in the USA although they were also issued in other countries such as the UK, and after a large enough portion of these mortgages defaulted the financial institutions who owned them suddenly realised they were worth a lot less than previously thought.

The financial institutions that own high rated bonds containing a percentage of sub-prime mortgages were, and still are, located throughout the world. This is why the problems created by this type of mortgage product, which were mostly granted in the USA, have spread to other countries. A financial institution such as a bank in Japan, for example, may have invested in a bond created in the UK that contains sub-prime mortgages which have subsequently gone bad. The assets (i.e. the bonds) on the balance sheet of the Japanese bank will then become less valuable so the net worth of the institution will decline. When this happens the Japanese bank will become less inclined to buy more financial products containing sub-prime mortgages, thus helping to freeze the flow of credit throughout the world. Compounding the problem is that no other institution will buy the bond from the Japanese bank, so it remains on its balance sheet which negatively affects the company’s share price.

Through the above example it can be seen how a swathe of bad mortgages in one country can contribute to a credit crunch on the other side of the world. This scenario is the root cause of the credit crunch and, although it is still a relatively new phenomenon, an effective solution to the problem has yet to be found.

The fallout from the first stages of the credit crunch is unprecedented. Financial institutions that were previously thought to be worth hundreds of billions of dollars shut their doors and fired their staff. Banks that have been operating for longer than a century have seen their profits plunge into massive losses and have been nationalised by their respective governments. Business of all sizes operating in a wide variety of markets have gone into administration or closed completely leaving their staff jobless. Even some of the largest companies in the world, most notably the big three auto makers of the United States, have begged hat in hand for government loans to help ensure their survival.

Never before has mankind experienced a situation in which trillions of dollars throughout the world have become frozen in the financial markets, leading to such disastrous consequences for businesses and individuals.

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