US sub-prime crisis - what's it all about?

Introduction

The sub-mortgage crisis started when US mortgage companies made loans worth hundreds of billions of US dollars to individuals who are unable to repay their mortgages.

The mortgage companies then sold the debts to financial institutions around the world, who in turn sold them on to pension funds and hedge funds. As the debts moved up the financial chain, investment banks repackaged the mortgage debts into complex structured products that were given a low risk market rating despite buyers not fully understanding the implications of the products they were investing in. As a result, it is impossible to determine where the debts that cannot be repaid are within the financial system and when the crisis first came to light the level of exposure was completely unknown.

This uncertainty has led to a collapse in investor confidence and means that the banks and financial institutions are reluctant to lend money. In response, banks are limiting the amount of money they lend and have increased interest rates on loans as a disincentive to borrowers. In addition, short term loans worth hundreds of billions of dollars are being recalled by banks in an attempt to reduce their exposure to credit risk.

There has been a lot of criticism about the credit rating agencies who certified many of the bad debts which have been bundled up and sold. There is a growing move to tighten up international regulation of the financial sector in order to reduce the risk of this type of situation arising again.

Implications

A recent example of the knock-on effects of the increased borrowing rates is Northern Rock. Unlike most UK banks, it raises the majority of its funds via the global wholesale credit market, which as a result of the US sub-prime crisis has dried up. Therefore, they are now finding it difficult to raise the cash to pay for additional mortgage lending which constitutes a major part of their business. As a result, it will be more difficult and costly for customers to get a mortgage. This in turn has reduced the rate of house price inflation which until recently seemed to be unstoppable.

There are already signs of an economic slowdown in the US, the world's biggest economy which are likely to penetrate the European and Japanese markets. The UK, as a major exporting nation, would also be affected as importing in other countries would reduce in light of the downturn.

On a more positive note, people will be encouraged to save money as the higher interest rates are more attractive, which in turn could lead to more long-term, stable investments.
Some also believe that an economic slowdown in the US could help re-balance the world economy, which has become overly dependent on the US as the driving force of world economic growth.