Entries Tagged 'finance' ↓

Readers Question: how did the recent financial crisis spread from the US and the EU to the rest of the world.

For more details see also: Financial crisis explained

It is fair to say the crisis started in the US.

• In the US many people took out mortgages they later couldn’t pay  back. These mortgage defaults caused many mortgage companies and banks to lose significant sums of  money and go bankrupt.
• It was also in the US where house prices first started to fall causing a negative wealth effect and fall in consumer spending.

Why Were other Countries Effected?

1. Foreign banks bought collateralised US debt. Many of these subprime mortgage loans were rebundled into CDOs and sold onto financial institutions around the world. For example, many British and European banks had exposure to these mortgage loans. Therefore, when defaults rose, European banks lost alot of money.

2. Global Credit Crunch. The banking system is internationally linked. When some banks started to lose money they became reluctant to lend to other. Therefore the international banking system became affected and banks stopped lending to each other and therefore it became difficult for firms and consumers to borrow from banks. This decline in bank lending contributed to a fall in aggregate demand. Even countries which didn’t have any exposure to subprime lending were effected by the global credit crunch

3. Global Trade. With the US entering recession, their demand for exports fell. So many countries experienced a decline in exports. This decline in global trade contributed to the global recession.

4. Confidence. Problems in the financial and banking sectors adversely affected confidence of consumers and firms leading to lower growth

5. Global Stock Markets. The financial problems of US and UK banks hit stock markets around the world 2007 and 2008 saw large fall in share prices which led to lower wealth and confidence. Leading to lower growth.

Typically, there is a weak correlation between stock markets and consumer spending. Only 20% of consumers have direct exposure to stock markets, and the wealth in stocks is not directly linked to spending. But, the sheer size of the stock market falls meant it did start to effect consumer spending and business investment.

In a recent post, UK personal debt, we looked at why UK debt had fallen for the first time since records began. Nevertheless, personal debt is still over £1.45 billion. Within this debt are many overburdened with debt from a variety of sources from personal loans to credit cards and store cards. Debt consolidation is a way to integrate all loans into a single payment. There are pros and cons to these schemes. It may be suitable for people in certain situations. But, it is good to get impartial advice before undertaking such a scheme. Unfortunately, financial literacy in the UK is often quite poor. I feel personal finance would make an excellent subject to be taught at school.

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Readers Questions: do you agree with bank bailouts why ?or why not?

I wrote here: Why we need to bailout the banks

The Great Depression was so severe because of the scale of banks who went bankrupt. Banks may not deserve to be bailed out, but, it was a necessity.

The big question is how to bailout the banks. For example, the Paulson plant and Greitner plan have involved purchasing of ‘toxic assets’ rather than taking public ownership.

I have never really evaluated all the detail of these plans. But, my feeling is that this is an expensive and inefficent way to bailout the banks.

You will get more detailed analysis here:

Financial policy despair - Paul Krugman

“…Question: what happens if you lose vast amounts of other people’s money? Answer: you get a big gift from the federal government — but the president says some very harsh things about you before forking over the cash….” Bailout for Bunglers

• UK Bank Bailout
• Markets fear scale of bank bailout

Definition: A contract for difference CFD is a contract which enables you to buy or sell a share in the future. Unlike futures they don’t necessarily have a fixed date for completion.

Essentially Contract for difference (CFDs) are used as a way for people to try and make money from predicting future share movements.

• If you expect share prices in a company to rise, you take a long position. This means you would take a contract to buy shares at todays price in the future.
• If you expect share prices in a company to fall, you take a short position. This means you would take a contract to sell prices at todays price in the future.

Example of Contract for Difference

For example, suppose shares in ICI are trading at 500p.

• A CFD with a long position means you could agree to buy 1000 shares in the future at £5. (cost = £5,000)
• CFDs usually require only a deposit of 10 – 20%. Therefore, your initial payment could be just 10% of £5,000 = £500
• If the share price of ICI rises, you will make a good profit. Suppose the price rises to £9.
• This means your CFD is now worth (£9-5) £4 * 1000 = £4,000. This is from an initial deposit of just £500.

If you had bought regular shares, your investment would have gone from £500 to just £900.

CFDs and Trading on the Margin

Because CFDs allow trading on the margin, your profit and losses can be magnified.

For example, suppose the shares of ICI fell from £5 to £4. You are sitting on a loss of £1 *£1,000. Therefore when the contract ends you would have to pay £1,000 in addition to the £500 deposit.

Why CFDs became Popular

CFDs became popular in the 1990s and 2000s. They are an example of how financial institutions are clever at developing new products to get around regulation and tax.

• It was away to trade in shares and avoid paying stamp duty.
• It is easier to influence share prices anonymously. e.g. if you take a big stake in a company, you are known. But, if you buy long CFDs to boost a share price, it is harder for markets to find out who you are.
• You can benefit from share price movements without owning any shares.
• They could be useful for people with insider information that share prices were set to fall. Though this is illegal it can be difficult to spot.
• They allow trading on the margin and so can magnify profits. This was attractive to hedge fund managers who gained big bonuses for making spectacular gains but were more immune if they made large losses.

Related

• Credit Default Swaps explained
• Collateralised Debt Obligations

Readers Question: You commented, “In the case of RBS they bought a stake in Amro a Dutch bank with heavy exposure to the US subprime market. Therefore RBS has had to write off a record £28bn and are now facing nationalisation”

What exactly is nationalisation and is it a good or bad thing for a consumer who banks with them?

Nationalisation occurs when the government takes control of a firm (or whole industry). It means that the government is the sole shareholder, and can decide how the firm is run.

At the moment RBS is a PLC, which means it is owned by shareholders. But, due to large losses it has required bailouts from the government. The government has gained an increasing share in the company in return for its bailouts.

If the government nationalised and took a 100% share, shareholders would probably get little if anything (but, then without government intervention RBS could go bankrupt)

How Will Nationalisation Affect the Consumer?

Not much would change immediately, the government says it doesn’t want to get involved in the day to day running of the bank. But, the government is unlikely to resist the temptation to meddle. In particular, it is more likely that RBS will be told to pass on the full interest rate cuts. The government may also tell RBS it has to lend more loans and mortgages to try and prevent an economic downturn. It is possible saving rates could decrease, but, RBS will probably need to be attracting deposits.

However, the cost of bailouts could lead to higher bank charges as the government makes Banks may greater insurance: see: consumers to foot bill for higher bank charges

• Nationalisation and bailout of banks
• Nationalisation of Northern Rock

Readers Question: There appears to be a lack of credit to companies whereas there are huge amounts of money in money market funds.
Why can’t those funds provide short term funding?

I’m not an expert in money markets, but, I would imagine some of the factors discouraging lending.

Financial institutions are nervous because of recession. A corportate loan has become a lot more risky because of the economic downturn. e.g. firms like Zavvi’s / Woolworth’s suddenly closing down. Therefore, even if banks have money to lend they would rather use it for secure investment. This is one reason why there is huge demand for US treasuries / bonds. Because even though they were only yielding 2%, they were considered one of the safest investments. Finance institutions are looking for low yielding, low risk investments before anything else.

Poor Liquidity. Although the sums involved in money markets is very high. Many hedge funds / finance institutions have had to write off bad loans meaning their balance sheets are pretty bad. Therefore, they are seeking to cover up their losses and improve their balance sheets by lending less – including even short term lending. The credit crunch is essentially characterised by banks not wanting to lend but hoard any cash.

Falling asset prices. With property prices falling and falling commercial prices forecast for 2009, loans become more risky.

Maybe these reasons apply more to long term investment. But, market sentiment is so low that finance institutions just don’t have the confidence to engage in normal lending practises.

Definition of Credit Default Swap – CDS are a financial instrument for swaping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond

• The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
• The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

Example of Credit Default Swap

• An investment trust owns £1 million corporation bond issued by a private housing firm.
• If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
• The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
• If the private housing firm doesn’t default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
• If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
• Therefore the hedge fund takes on a larger risk and could end up paying £1million

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Example of Credit Default Swap

Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.

Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.

If the firm (Riskymortgage.co.uk) default on the loan, then the hedge fund will pay Lloyds TSB the value of the loan.

Thus Lloyds TSB have insurance against loan default. The hedge fund has the opportunity to make profit, so long as the firm does not default on the loan.

The more risky the loan, the higher will be the premium required on buying a credit default swap.

Why Would People Buy Credit Default Swaps?

1. Hedge against risk. Suppose an investment fund owned mortgage bonds from riskymortgage.co.uk. It might be worried about losing all its investment. Therefore, to hedge against the risk of default, they could purchase a credit default swap from Lloyds TSB. If riskymortgage.co.uk defaulted, they will lose their investment, but receive a payoff from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security.

2. Speculation e.g. risk is underpriced.

Suppose a hedge fund felt riskymortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt was defaulted, then they would make profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

Clearly the more risky a bond is the higher premium will be required from a buyer of a credit default swap. It is argued that credit default swaps provide an important role in indicating the riskiness / credit worthiness of a firm.

3. Arbitrage

If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market  to respond to signals.
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Given concerns over the financial system, many British savers may be anxious about the future of British banks.

Yesterday, shares in HBOS fell 18% (at one point in the day it had fallen 35%.) Shares in Barclays and Royal Bank of Scotland also posted double digit falls.

British banks are not directly exposed to the same subprime mortgages as in America. However, they are indirectly exposed to the problems stemming from America. The problem is that banks no longer just rely on deposits to make loans and mortgages. They rely on lending a mortgage and then being able to rebundle the debt onto other finanical instutions. With Lehman brothers going under, this business plan only becomes more difficult.

The reason that Northern Rock got into difficulties, last year was that it had the highest ratio of mortgages financed by reselling rather than deposits.

British banks will also be increasingly vulnerable from the state of the housing market. WIth house prices falling, the number in negative equity is increasing. A recession and rising unemployment could create a real problem of bad debts in the UK.

What Should I do With My Savings?

I think the Banking system will be able to weather the storm, althought the government dithered over Northern Rock, at the end of the day they realised they couldn’t let it go under.

However, these are not normal times, there is a lot to be said for diversifying your life savings. Don’t put all your wealth into one finanical institution. Consider Northern Rock or National savings, both of which are guaranteed by the government.

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense – how can you predict 10 out of 3? Did you mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions.
Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later, it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

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Yesterday, the bank of England  offered a scheme to bailout the banking sector by offering to exchange ‘unpopular’ mortgage debt for government backed securities.

The money markets have struggled since last summer and the American subprime crisis. This has led to a shortage of funds for mortgages and increased cost of mortgages.

I wrote an in depth analysis here: – Bank of England Bailout for Mortgage companies.

It is not certain how successful it is going to be. Abbey announced this morning that they will increase their mortgage rates anyway.