How a credit crunch may hurt the world economy
As troubles in the US housing market ripple across the global economy, the health of banks has become one of the biggest financial uncertainties for 2008.
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What's 'SIV' got to do with it?Skip to next paragraph
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Don't know what a SIV is? The financial industry has grown ever more creative in recent years, and now one of the biggest challenges is sorting out the unknown risks of complicated products. Consider:
• Banks set up structured investment vehicles (SIVs), which derive income by making loans with borrowed money. Now, after other firms stopped lending to these SIVs, banks in effect are being forced to lend to themselves. They are bringing the SIV loans back onto their books – and marking down their value to reflect new realities. Europe's biggest bank, London-based HSBC, recently said it will absorb about $45 billion in SIV assets.
• Similarly, banks bundled a wide range of loans into so-called collateralized debt obligations (CDOs). These were designed to provide bond-like streams of income to investors. But as it turned out, credit-rating agencies failed to accurately gauge the risk of default. Some banks, having invested in their own CDO products, face huge losses here.
•Another burgeoning financial product line is called credit default swaps – contracts designed to insure against loan losses. But these contracts haven't been fully tested.
Since no one knows how all this will shake out, "the lack of transparency … makes banks very fearful of lending to one another," says Mr. Lachman, now a scholar at the conservative American Enterprise Institute in Washington. That's worrisome, because in normal times, daily interbank lending is a routine facet of the economy.
Is world banking system in trouble?
Not unless things worsen dramatically, experts say.
Some financial firms – those most exposed to the subprime home-loan sector – face much bigger losses than others. Among the hardest hit is America's Citigroup. But Citi and others are still making new loans, and have a cushion against losses. Some may need to expand that cushion by cutting dividends or seeking capital from outside investors.
In this scenario, the global economy can escape major damage.
"That's an optimistic view," Ms. Packard says. "We see it that way."
But she says a pessimistic scenario is also possible, if global economic growth decelerates more than expected. That could push down prices of many assets – real estate, stocks, and more. Bank losses would multiply, and lending would be curbed more sharply. The downward pressure on asset prices could come partly from investors such as hedge funds if they are forced to "deleverage," to sell assets to cover losses on other investments made with borrowed money.
"It's like a lake where parts of the ice are very thin" for the economy to keep skating on, Packard says.
Even the optimistic case creates some headwinds of tighter credit.