Bellerbys Economics - Mr Stephenson

Wednesday, September 05, 2007

Sub-Prime Disaster Explained

A couple of weeks ago the US sub-prime market collapsed - sending the world's financial centres into a panic - share prices plummetted - things were looking bad - and then the central banks stepped in to inject an incredible $400 billion dollars to rescue many of the major banks and financial institutions that had been put at serious risk by the catstrophe - so what's it all about?

For the last 10 years, financial institutions in the US have been lending money more-and-more easily to Americans to buy homes. Many of these loans have been in the sub-prime market. Basically, these are high-risk borrowers who would not normally/should not be able to borrow the huge sums of money being offered.

In order to spread their risk, these financial institutions then passed on the loans to a variety of other lenders through a complex range of refinancing packages. Every time money moves hands, of course, someone takes a commission - and someone has to pay for it - in this case, the poor borrowers at the bottom of the pile - those least able to do so.

As money for mortgages became easier and easier, house prices rose rapidly. The original borrowers were then able to borrow more money using the increase in the value of their houses to back the loan.

This couldn't go on forever. Eventually, interest rate rises in the US drove many borrowers into bankruptcy, house prices collapsed as demand fell, the financial institutions panicked. Some very major banks looked seriously at risk - including France's no.1 bank, BNP.

The world's central bankers stepped in. They injecting $400 billion into the market, often buying securities or shares that they wouldn't normally touch by a million miles.

In the end, we will all pay for this disaster. As share prices fall, our pensions will be hit, businesses will find it harder to raise money for investment, confidence will suffer, many of the investments made by the central banks will fail diminishing the national asset.

The question is - will we learn from this?

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