ABSTRACT
At the time of writing the world was being shaken by an upheaval in the financial sector comparable to that of 1929. These events in world financial markets have, to say the least, given economists pause for reflection. The explanations given for the collapse of the structure are clear and convincing. Individual banks extended credit to those wishing to buy homes with little regard for the capacity of the borrowers to pay. If the unhappy borrower did not fulfil his obligations the bank recovered the home, the price of which was rising. The loans in question were distributed among banks worldwide, through instruments which packaged loans of varying quality together. This, we were told, was a good thing because it diversified the risk. However, with a weakening of the US economy the number of defaulters grew and, worse, prices in the housing market no longer rose. At this point, banks started to examine their positions and to evaluate the losses and potential losses due to the ‘subprime’ loans contained in the instruments they were holding. Many major banks found that their positions were more than delicate and they
began to seek ways of redressing them. However, the crucial problem was that banks did not know which of their counterparts were in trouble and thus stopped lending to other banks. The freezing of the interbank market brought thewhole system to a halt since banks are constantly in need of being able to finance various transactions and habitually borrow from each other to do so. The solutionwhichmay ormay not eliminate or reduce the problem was, at the time of writing, to inject enormous amounts of money into the system, to rescue AIG, a huge insurance company whose credit-default swaps underpinned the credit market, and to essentially guarantee the bad debt. In addition, the two largest mortgage banks in the US were effectively nationalised. Several banks in Europe were rescued from bankruptcy and to all intents and purposes nationalised. The crisis had global consequences and an important impact on the real economy. Despite the concerted efforts of the major central banks and governments, it is far from clear how long the consequences will last.
