The Credit Crunch

So what is the Credit Crunch and how does it impact on Wall Street?

Well the credit crunch originated with the issuance of so called Sub-Prime mortgages. Sub Prime Mortgages are mortgages that were issued to people with poor credit histories at a higher rate of interest than a normal mortgage.

The problem was and is that by definition these mortgages are more likely to default. In other words it is more likely that people who took out these mortgages would not be able to afford the re-payments, especially if interest rates increased.

The problem was made worse because many people were sold mortgages that they simply could not afford from day one.

Now, these sub-prime mortgages were bundled together and sold on to banks and other investors worldwide in the form of derivative products. Investors bought them in the hope of making a return on their investment.

However, with the deterioration in the US property market and the fact that many of these mortgages were destined to default, these derivative products lost their value.

Several banks and insurance companies had very large exposures to these assets, so much so that some of them went bankrupt or needed Federal / Government help to stay in business.

Examples are Bear Stearns, who were taken over by JPMorgan with help from the US Government; AIG which is a massive insurance company had to be bailed out with multi billion dollar funding; Lehman Brothers collapsed; Warren Buffett pumped $5 billion into Goldman Sachs and the list goes on.

The Credit crisis was not limited to the US. The crisis has spread to Europe and beyond prompting a worldwide political response.

So the effect on Wall Street is what? Well, banks are afraid to lend money to each other, because they are afraid that more banks will fail. This impacts on Main Street too, as it becomes more difficult for small and large business to get credit, which prior to the crisis was easy. So this impacts on the wider economy.

In the week from 6^th October to 10^th October 2008, the Dow Jones Index fell by the greatest amount since the Stock Market crash of 1987. Most of the major Stock Markets in the US have fallen by more than 40% since their peak last year, and this trend has been mirrored worldwide.

 

 

The Bailout Plan

What is the Bailout Plan?

 

Well due to the massive problem that is the Credit Crisis, a concerted political response was deemed necessary. The main points of the bailout plan were as follows:

1. Direct intervention was made to ensure that some banks / insurance companies were not allowed to fail. Examples of these are AIG and Washington Mutual.
2. The Federal reserve made Billions of Dolllars available to free up the credit markets (with limited success).
3. A major ($700 Billion) plan was announced, that would effectively purchase the toxic assets (the derivative asstes invested in sub-prime) from banks.
4. A joint interest rate cut of 50 basis points (0.5%) was announced simultaneously across several world central banks, including the Federal Reserve in the US, the ECB (European Central Bank), The Bank of England, Swiss Central Bank and some others. (Note that Japan were in favour of the joint approach, but because their interest rates are so low, they could not reduce them any further).

Whats Next?

That’s a good question ! The hope is that the credit markets will ease and that banks will start lending to each other. This would have a positive knock-on impact on the overall economy.

There is  a lot of fear on the Stock Markets at the moment. The volatility is at record high levels, which means that we can expect huge swings in both directions on the Stock Markets, similar to what we have already seen. It is not unusual to see 500 – 1000 point swings on the Dow Jones Index these days.

There are several unknowns that are weighing heavily on the markets. There is a recession in most developed economies today. The unknown is how bad and how long will this recession be?

The other unknown is political. A new President of the USA will be voted in in November 2008. This usually has an impact on the Stock Market.