JAN 22 2008 FROM BBC Fed slashes rates in shock move The US Federal Reserve has slashed interest rates to 3.5%, its biggest cut in 25 years. The Fed, the US central bank, is trying to keep the US economy from slumping into recession and US and European stocks took heart from the move. Some analysts called the Fed move an act of "obvious panic" after Monday's global share slide. US President George W Bush has said that emergency economic measures will be passed soon. The Fed's move, which cut interest rates from 4.25% to 3.5%, came as a complete surprise, as it was taken a week before its rate-setting Open Market Committee meeting scheduled for 29 and 30 January. It came after huge declines in shares across Asia and Europe on Monday, with London's benchmark FTSE 100 suffering its biggest one-day fall since the attacks of 11 September 2001. +++++++++++++++ FROM LA TIMES Jan 22 The central bank takes emergency action amid a global stock sell-off and increasing fears of a U.S. recession. By Peter G. Gosselin, Los Angeles Times Staff Writer January 23, 2008 WASHINGTON -- The Federal Reserve, dispensing with caution and ordering a steep interest rate cut, succeeded Tuesday in curbing an incipient panic in global stock markets. But interest rate cuts, which the Fed signaled its willingness to carry further in the weeks ahead, address some but not all of the sources of trouble in the economy both here and abroad, analysts said.
The three-quarters-of-a-point cut to 3.5% in the federal funds rate -- the largest one-time reduction in almost two decades -- helped avert an immediate crisis in the U.S stock market. Although the bellwether Dow Jones industrial average initially tumbled 465 points despite the Fed's surprise announcement before the opening bell, the index rallied
2 to end the day down 128 points. The Fed's action, which slashed the interest rate that banks charge each other for shortterm loans, had an even more positive effect in Europe: Falling markets reversed course and closed higher for the day. Economists remained deeply divided, however, on whether the central bank's action would have a lasting effect on the combination of problems dogging the nation: the sub-prime mortgage crisis, the fall in housing prices and growing liquidity problems among some of the nation's largest banks and other financial institutions. Ed McKelvey, a senior U.S. economist at Goldman Sachs in New York, said rate reductions could help by making it easier for consumers to keep buying and by easing the pain when rates on adjustable sub-prime mortgages rise. But Stephen Roach, chairman of Morgan Stanley Asia, took a distinctly different view. "I do not believe that aggressive Fed rate cuts will resolve the extreme imbalance between supply and demand in the U.S. property market . . . nor restore the functioning of the credit markets to their pre-crisis state," he said in a message from the World Economic Forum in Davos, Switzerland. Until now, the Fed has generally moved slowly in reacting to the nation's spreading economic problems. For much of last year, Fed officials predicted that the sub-prime crisis would remain confined and that the real danger to the economy was inflation, not faltering growth. When they finally changed their minds, they made a half-point cut in the funds rate at their September meeting, then followed up with two modest quarter-point reductions in October and December. But Fed Chairman Ben S. Bernanke has apparently decided that the dangers to U.S. growth are substantially greater than the central bank had thought. When global stock markets plunged Monday, signaling that anxiety about the economic outlook was spreading abroad, Bernanke managed to convince most of his Fed colleagues of the need for the three-quarter-point cut. It was the biggest single reduction in the funds rate since the central bank began using the rate as an economic management tool around 1990 and the largest inter-meeting emergency rate cut since 2001. And the Fed signaled that the latest cut was unlikely to be its last as it grapples with the current situation. In a statement accompanying news of the reduction, central bank policymakers said "appreciable downside risks to growth remain" and they promised to "act in a timely manner as needed to address those risks."
3
Fed watchers predicted the central bank would shave an additional half a point from the funds rate when its policymaking Federal Open Market Committee meets next Tuesday and Wednesday, and could ultimately drive the rate down to 2.25%. As recently as last September it stood at 5.25%. "They've decided they need to cut a lot," McKelvey said. "When they get to next week, they're going to see data showing them the economy is continuing to slow and probably still worse market conditions. So they're going to figure: "Why not cut a lot?" One of the most immediate challenges posed by Tuesday's decision to take dramatic action in the wake of plunging securities markets is that the central bank's mandate is to keep the economy growing as speedily as possible without sparking inflation, not to prop up the stock market. "They're in a tough spot," said Vincent Reinhart, a former senior Fed staffer who is now a scholar with the American Enterprise Institute, a Washington think tank. "The problem isn't with easing interest rates -- the economy needs that," he said. "The problem is with timing the ease so it looks like you're doing it explicitly to help the markets." But given the economy's current situation, it is hard to disentangle what is strictly an economic problem from what's a market one. In its statement, the Fed said it acted because of "a weakening of the economic outlook and increasing downside risks to growth," adding that "broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets." In essence, the Fed is having to tackle two problems at once. The first is the bursting of a housing bubble that appears to be causing a slowdown in consumer spending and a drop in construction employment. Together, those developments threaten a traditional recession or contraction of growth. The second problem is the bursting of a credit bubble caused in large measure by sudden doubts about the safety of mortgage-backed securities, as loan defaults soar. This second bubble has caused many financial institutions, reeling from losses on mortgage-backed securities, to sharply curtail their lending. That in turn threatens businesses with being unable to borrow in order to operate, and that is rattling the stock market. Bernanke acted after foreign markets plunged, analysts said, because policymakers wanted to avoid a global financial contagion similar to the so-called Asian contagion that occurred in the late 1990s.
4 Then, financial troubles in emerging markets in Thailand, South Korea and elsewhere ended up threatening economies as diverse as Russia's and Brazil's. But the central bank chairman also was concerned that a U.S. slowdown would stall the economies of other countries, which U.S. policymakers have been counting on to help the nation dodge recession by being ready purchasers of American goods and services. Not all of Bernanke's colleagues lent their support to swift action. Eight of 10 voting members of the rate-setting committee favored the cut. But Fed Gov. Frederic Mishkin was traveling and unavailable to vote. And Federal Reserve Bank of St. Louis President William Poole voted against the move because he "did not believe that current conditions justified" a cut before the Fed's regularly scheduled meeting, the Fed's statement said. Separately, the Bank of Canada lowered its key interest rate by a quarter of a point to 4% and signaled it was prepared to cut further to protect Canada from a U.S. slowdown. Analysts said the Fed's decision to start cutting sharply was likely to increase pressure on the central banks of other industrialized nations to make similar cuts. But the Bank of England said it had no plans to change the date of its next rate decision -- a two-day meeting in London that starts Feb. 6. In a related decision, the Fed's Board of Governors approved a three-quarters-of-a-point cut to 4% in the central bank's discount rate, the interest the Fed charges for making short-term loans to banks. Bernanke and his colleagues have been experimenting with ways to turn the discount rate into a more powerful economic management tool. Until recently, banks have viewed borrowing directly from the Fed as an admission that they were in financial trouble and have feared that it would attract central bank regulators to carefully scrutinize them. Critics have said that the Bernanke Fed has engaged in far too much gradualism over the last year as the combination of the sub-prime mess, the housing downturn and the credit crunch has weakened the economy. They have warned that it may be too late even now that the central bank has decided on a course of making steep rate cuts. In making their case, they have pointed to the Fed's experience in 2000 and 2001. The central bank under the leadership of Chairman Alan Greenspan raised interest rates through the first half of 2000 even as the tech bubble burst and the stock market plunged, then held them at a comparatively high 6.5% through the rest of the year. Fed policymakers eventually realized that the stock plunge was causing the economy substantial problems only at the beginning of 2001. In a dramatic turnabout, they began a rate-cutting exercise that included five half-point cuts from January to May of that year and brought the funds rate down to a mere 1.75% by year's end from 6.5%. But, critics point out, even with such substantial cutting the country was unable to dodge
5 a brief recession from March to November of 2001, one that was most likely ended not by the Fed but by a burst of public consumption in the wake of the 9/11 terror attacks. peter.gosselin@latimes.com
Good for borrowers, bad for savers
template_bas
template_bas
If you're in debt, the Fed rate cut could give you immediate relief. If you bank up your money, it'll grow a lot slower. By Kathy M. Kristof, Los Angeles Times Staff Writer January 23, 2008 For many Americans, the effects of the Federal Reserve's aggressive rate cut will be swift and striking. The average borrower could save hundreds of dollars within a few months -and the average saver could lose just as much. Fortunately, as far as the strength of the consumer-driven economy is concerned, there are fewer people relying on the income earned by their investments than there are people heavily in debt. With $2.5 trillion in consumer debt outstanding -- and trillions more in home equity lines of credit and adjustable-rate mortgages -- a cut of the magnitude made Tuesday can translate into billions of dollars in spending power.
"It's bad for seniors who are living on fixed incomes, but this gigantic baby boom generation is largely made up of borrowers," said Gary Schlossberg, senior economist with Wells Fargo Capital Markets in San Francisco. Wendy and Nicholas Stanton, who work in the entertainment industry, are among the borrowers, with an $83,000 equity line of credit secured by their house in Pasadena. If the rate on their credit line drops by the same amount the Fed cut its key short-term rate
6 -- three-quarters of a point -- it will shave $50 or so off the line's monthly payment. The Stantons say they'll spend that money, which is what the central bank wants them to do. "The way our industry and the housing market are at this moment in time, even a $5 payment cut is significant to us," said Wendy Stanton, an art director out of work because of the writers strike. The nation's 75 million homeowners are likely to feel the most significant and immediate benefits. Home equity lines of credit are often tied to the prime rate and other short-term indexes that fall in lock step when the Federal Reserve cuts its benchmark rate. And conventional mortgage rates tend to follow rates on long-term Treasury bonds, which fell further Tuesday after the Fed acted. Already, rates on 30-year fixed mortgages are at their lowest levels in at least 2 1/2 years. Last Friday, the best rate available on a 30-year loan was 5.5%, said Jeff Lazerson, president of Mortgage Grader, a Web-based loan shopping service. By Tuesday afternoon, it had fallen to 5.125% for borrowers willing to pay 1 percentage point in upfront costs. That's likely to touch off a refinancing boom, he said. "For six months, you could have shot a cannon through here and not hit anyone," he said. "Today, the phones lit up like we were having an electrical storm." What's more, $25 billion to $30 billion in adjustable-rate mortgages are "repricing" each month throughout 2008, said Greg McBride, financial analyst with BankRate.com. Because these loans typically adjust once or twice a year, Tuesday's rate cut combines with other recent Fed cuts to provide many of the borrowers with a huge break. "This is going to save a lot of people from completely unmanageable payment increases," McBride said. Someone with a $200,000 ARM would have been hit with a $370-a-month payment increase had the Fed not acted in recent months to cut short-term rates a total of 1 3/4 percentage points, he said. Now the hike will probably be in the range of $100 a month. "For many homeowners, those manageable rate resets will be the difference between keeping a home or losing it," he said. McBride said the rate cut could prove far more significant than the lending industry's pledge to help certain sub-prime borrowers. "This affects everyone," he said.
7 Because the vast majority of credit cards are issued at variable interest rates, credit card debtors stand to benefit too. The latest cut in the Fed's key rate will probably be passed on to consumers within one to three billing cycles, said Justin McHenry, research director at Index Credit Cards.com in Cleveland. A person with $5,000 in credit card debt will save about $3 a month, according to Bill Hardekopf, chief executive of LowCards.com. That's chump change, to be sure, but for those with big balances it may be enough to help them meet minimum monthly payments and start whittling down their obligations. Eventually, even the cost of car loans may edge lower, though those rates tend to be stickier, moving far more slowly than the rates on debts that are directly tied to prime or Treasury-rate indexes. For all the rejoicing among the indebted, there was sorrow among the ranks of savers. Rates on money market accounts and certificates of deposit have been dropping in recent weeks, said Ray Montague, manager of deposit research at Informa Research Services in Calabasas. And they'll be dropping more within days. Several banks said their money market rates would come down as of midnight Tuesday, Montague said. In Arcadia, Lonell Spencer, a 79-year-old retired machinist who has tens of thousands of dollars in CDs, braced to lose hundreds a month in interest. "We don't have an opulent lifestyle as it is," he said. "This is going to make a difference." David Jones, president of the Assn. of Independent Consumer Credit Counseling Agencies in Orlando, Fla., saw both bad and good in the Fed's move. Jones helps highly indebted borrowers get back on their feet, and lower interest rates are good for them. At the same time, he couldn't help feeling a little sorry for himself. "I have certificates of deposit," he said. "Some of them are locked in, but the newer CDs are going to be at lower rates. And the amounts I get on my savings and checking account, which are really low, are going to go even lower."
REMEMBER BLACK MONDAY?
The slump was a sign that the markets were not satisfied with the US president's proposed economic stimulus agenda worth at least 1% of gross domestic product, or about $145bn (£74bn), announced last week.
8 This has led to speculation that the size of the package could be increased. Mr Bush met top Republican and Democrat lawmakers to thrash out details and the timeframe of the plans, which will include tax relief for business and individuals, in an effort to get the desired legislation enacted quickly. Mr Bush said: "I believe we can find common ground and get something done that's big enough... so that an economy that is inherently strong gets a boost." US Senate Majority Leader Harry Reid said Congress could agree laws to lift the US economy within three weeks. Cautious reaction Cautious optimism greeted the Fed's action, stemming heavy falls on the European and US stock market indexes. The UK's FTSE 100 index closed 2.9% higher at 5,740.1 after falling more than 4% earlier. France's Cac also bounced back but Germany's Dax closed 0.3% down. The markets themselves now threaten to exacerbate the very downturn of which they are so scared
In the US, shares on the Dow Jones and S&P 500 indexes still trailed, but their declines were not as sharp as when they had first opened. The Dow Jones index of largest shares finished more than 1% down at 11,971.2. "We're not out of the woods yet... we're still down on the day... but clearly the Fed ratecut move was well received by traders," said Michael James, senior trader at Los Angeles-based investment bank Wedbush Morgan. "At least it was an attempt by the Fed to get in front of the negativity." However, other analysts were less convinced on the Fed's ability to take control of the current economic situation. "Unfortunately they have no power to reverse what in my opinion is the worst post-war recession," said Michael Metz, chief investment strategist at Oppenheimer in New York. 'This is huge' The last two such emergency cuts were on 17 September 2001, shortly after the attacks of 11 September, and on 3 January 2001, in the wake of the dotcom bust.
9 The last time the Fed cut rates as much as three-quarters of a percentage point was in August 1982, almost 26 years ago. What if, after the Bernanke bounce, stock markets continue to fall?
"This is huge," said the BBC's business editor Robert Peston. "And it is a big risk. If this doesn't work, then people will say they have nothing left in their locker." "The Fed is spooked by the markets, so no wonder the Fed felt it needed to take drastic action," said the BBC's economics editor Evan Davis. "Even if it isn't going to work as well as it did in 2000 [in response to the dotcom crisis], it might at least prevent markets and the economy driving themselves ever deeper in to a quagmire." Analyst Jeremy Stretch of Rabobank, described the Fed's move as "a sign of panic". "But it certainly indicates that the Federal Reserve wants to be seen as taking action over the concerns of an economic downturn," he said. Yet despite the Fed's extensive cut in rates, US investment bank Merrill Lynch said at the start of this month that, in its opinion, the American economy was already in recession. Another investment bank, Goldman Sachs, has also warned that recession is now likely. Sub-prime woes The sharp downturn in the US economy has centred on the slump in the American housing market over the past year. Against a backdrop of higher US mortgage rates, home loan defaults and repossessions hit record levels last year, specifically in the sub-prime sector. This industry specialises in higher risk loans to people on low incomes or those with poor credit histories. As the sub-prime mortgage sector hit crisis point, it triggered record losses at some of America's largest banks. It also caused the global credit squeeze, as much of this sub-prime debt was repackaged into wider debt offerings that were bought by banks and other investors around the world.
10 As a result, global banks are now much less willing to lend to each other, or to homes and businesses, until the full extent of the sub-prime exposure is known. Story from BBC NEWS: +++++++++++++++++ Top bosses fear global recession By Tim Weber Business editor, BBC News website, Davos
A global recession has now become the biggest threat to companies, according to a global survey of top chief executives. Business confidence is also falling for the first time in five years, according to PricewaterhouseCoopers' survey. The corporate gloom, however, is limited to bosses in the United States and Western Europe. In Asia business confidence is soaring, with 90% of Indian bosses saying they are "very confident". While confidence numbers are down overall, half of all chief executives still claim to be "very confident" about their company's future. That is twice the level of 2003, the last time confidence levels were falling. However, the survey of 1,150 top bosses in 50 countries does not yet take account of the most recent stock market turmoil, as it was conducted during the last three month of 2007. Rampant Asia, bedraggled USA The survey, presented on the sidelines of the World Economic Forum in Davos, suggests sharp differences in corporate fortunes. The possibility that a downturn could worsen into recession looms large in established economies like the US and Western Europe Samuel DiPiazza, PricewaterhouseCoopers Speaking of a "tale of two worlds", Samuel DiPiazza, the global chief executive of accounting firm PricewaterhouseCoopers, said "the credit crunch and the slowdown in the Western economies have created a clear split in confidence levels of CEOs around the world". Bosses in emerging economies believe that they are still for rapid expansion.
11 While Indian bosses may be the most confident, their Russian and Chinese peers are catching up. In China, 73% of chief executives are very confident their firms will grow over the next 12 months, up from last year's 60%; Russia registers a real leap of confidence, up from 35% to 73%. This is in stark contrast to bosses in Western Europe, with 44% expecting their companies to grow (a drop of 8 percentage points), and especially the United States, where only 36% are very confident - a drop of 18 points from 54%. Faring worst are Italian executives. Just 19% believe in their firm's growth prospects, down from 52% one year ago. "The possibility that a downturn could worsen into recession looms large for [chief executives] in established economies like the US and Western Europe," said Mr DiPiazza. The one exception is Germany, where 57% of top managers feel very confident. Mr Di Piazza speculated that Germany's strong export industry had helped to sustain corporate fortunes. Corporate threats While recession fears have jumped to the top of the list of potential corporate problems, the old perennial "fear of over-regulation" still makes it into the top three. Bosses are also concerned whether they will be able to recruit and keep the best people to run their business. Human resource experts speak of a "war for talent", and two-thirds of all business leaders say that dealing with people issues is the best use of their time. Climate change - last year's hot topic in Davos - has dropped sharply in the list of corporate threats. Having said that, 80% of executives surveyed said governments should act to reduce emissions, which sits uneasily with their complaints about over-regulation. Story from BBC NEWS:
++++++++++++++++++++++++++++++++ Financial crises: Lessons from history Analysis By Steve Schifferes Economics reporter, BBC News
12 The current market jitters are centred on disturbances in the world's credit markets. Worries about the viability of sub-prime mortgage lending have spread around the financial system, and the central banks have been forced to pump in billions of dollars to oil the wheels of lending. But what happened in previous financial crises, and what are the lessons for today? There have been a growing number of financial crises in the world, according to the International Monetary Fund (IMF). Among the key lessons of previous major financial crises are:
Globalisation has increased the frequency and spread of financial crises, but not necessarily their severity Early intervention by central banks is more effective in limiting their spread than later moves It is difficult to tell at the time whether a financial crisis will have broader economic consequences Regulators often cannot keep up with the pace of financial innovation that may trigger a crisis.
THE DOT.COM CRASH, 2000 During the late 1990s, stock markets became beguiled by the rise of internet companies such as Amazon and AOL, which seemed to be ushering in a new era for the economy. Their shares soared when they listed on the Nasdaq stock market, despite that fact that few of the firms actually made a profit. The boom peaked when internet service provider AOL bought traditional media company Time Warner for nearly $200bn in January 2000. But in March 2000, the bubble burst, and the technology-weighted Nasdaq index fell by 78% by October 2002. The crash had wider repercussions, with business investment falling and the US economy slowing in the following year, a process exacerbated by the 9/11 attacks, which led to the temporary closure of the financial markets. But the Federal Reserve, the US central bank, cut interest rates throughout 2001, gradually lowering rates from 6.25% to 1% to stimulate economic growth. LONG-TERM CAPITAL MANAGEMENT, 1998
13 The collapse of hedge fund Long-Term Capital Market (LTCM) occurred during the final stage of the world financial crisis that began in Asia in 1997 and spread to Russia and Brazil in 1998. LTCM was a hedge fund set up by Nobel Prize winners Myron Scholes and Robert Merton to trade bonds. The professors believed that in the long run, the interest rates on different government bonds would converge, and the hedge fund traded on the small differences in the rates. But when Russia defaulted on its government bonds in August 1998, investors fled from other government paper to the safe haven of US Treasury bonds, and interest rate differences between bonds increased sharply. LTCM, which had borrowed a lot of money from other companies, stood to lose billions of dollars - and in order to liquidate its positions it would have to sell Treasury bonds, plunging the US credit markets into turmoil and forcing up interest rates. So the Fed decided that a rescue was needed. It called together the leading US banks, many of whom had invested in LTCM, and persuaded them to put in $3.65bn to save the firm from imminent collapse. The Fed itself made an emergency rate cut in October 1998 and markets soon returned to stability. LTCM itself was liquidated in 2000. THE CRASH OF 1987 US stock markets suffered their largest peacetime one-day fall yet on 19 October 1987, when the Dow Jones Industrial Average index of shares in leading US companies dropped 22% and European and Japanese markets followed suit. The losses were triggered by the widespread belief that insider trading and company takeovers on borrowed money were dominating the markets, while the US economy was entering into an economic slowdown. There were also worries about the value of the US dollar, which had been declining on international markets. These fears grew when Germany raised a key interest rate, boosting the value of its currency. Newly-introduced computerised trading systems exacerbated the stock market declines, as sell orders were executed automatically. Concerns that major banks might go bust led the Fed and other major central banks to lower interest rates sharply.
14 "Circuit-breakers" were also introduced to limit program trading and allow the authorities to suspend all trades for short periods. The crash seemed to have little direct economic effect and stock markets soon recovered. But the lower interest rates, especially in the UK, may have contributed to the housing market bubble of 1988-89 and to the pressures on the pound sterling which led to the devaluation of 1992. The crash also showed that global stock markets were now closely linked, and changes in economic policy in one country could affect markets around the world. Laws on insider trading were also tightened up in the US and UK. US SAVINGS AND LOAN SCANDAL, 1985 US Savings and Loans institutions were local banks which made home loans and took deposits from retail investors, similar to building societies in the UK. Under financial deregulation in the 1980s, they were allowed to engage in more complex, and often unwise, financial transactions, competing with the big commercial banks. By 1985, many of these institutions were all but bankrupt, and a run began on S&L institutions in Ohio and Maryland. The US government insured many of the individual deposits in the S&Ls, and therefore had a big financial liability when they collapsed. It set up the Resolution Trust Company to take over and sell any S&L assets that it could, including repossessed homes, taking over the bankrupt institutions. The cost of the bail-out eventually totalled about $150bn. However, the crisis probably strengthened the bigger banks by weeding out their weaker rivals, and laid the groundwork for the wave of mergers and consolidations in the retail banking sector in the 1990s. THE CRASH OF 1929 The Wall Street crash of 1929, "Black Thursday," was an event that sent the US and indeed the global economy into a tailspin, contributing to the Great Depression of the 1930s. After a huge speculative rise in the late 1920s, based partly on the rise of new industries such as radio broadcasting and carmaking, shares fell by 13% on Thursday, 24 October. Despite efforts by the stock market authorities to stabilise the market, stocks fell by another 11% the following Tuesday, 29 October.
15 By the time the market had reached bottom in 1932, 90% had been wiped off the value of shares. It took 25 years before the Dow Jones industrial average recovered to its 1929 level. The effect on the real economy was severe, as widespread share ownership meant that the losses were felt by many middle-class consumers. They cut their purchases of big consumer goods such as cars and homes, while businesses postponed investment and closed factories. By 1932, the US economy had declined by half, and one-third of the workforce was unemployed. The whole US financial system also went into meltdown, with a shutdown of the entire banking system in March 1933 by the time the new President, Franklin Roosevelt took office and launched the New Deal. Many economists on both left and right have criticised the response of the authorities as inadequate. The US central bank actually raised interest rates to protect the value of the dollar and preserve the gold standard, while the US government raised tariffs and ran a budget surplus. New Deal measures alleviated some of the worst problems of the Depression, but the US economy did not fully recover until World War II, when massive military spending eliminated unemployment and boosted growth. The New Deal also introduced extensive regulation of financial markets and the banking system through the creation of the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC), and the separation of commercial and retail banking through the Glass-Steagall Act. OVEREND & GUERNEY, 1866; BARINGS, 1890 The failure of a key London bank in 1866 led to a key change in the role of central banks in managing financial crises. Overend and Guerney was a discount bank which provided money for commercial and retail banks in London, the world's financial centre. When it declared bankruptcy in May 1866, many smaller banks were unable to get funds and went under, even though they were otherwise solvent. As a result, reformers like Walter Bagehot advocated a new role for the Bank of England as the "lender of last resort" to provide liquidity (cash) to the financial system during
16 crises, in order to prevent a failure of one bank spilling over and affect all the others ("systemic failure"). The new doctrine was implemented in the Barings Crisis in 1890, when losses by a leading UK bank, Barings, made on its investments in Argentina, were covered by the Bank of England to prevent a systemic collapse of UK banking. Secret negotiations by the Bank and London financiers led to the creation of an £18m rescue fund in November 1890, before the extent of Barings' losses became publicly known. The bankers also organised a committee to renegotiate the outstanding debts owed by Argentina, but a banking crisis engulfed the country and foreign lending to Argentina dried up for a decade. Story from BBC NEWS: Housing meltdown hits US economy By Steve Schifferes Economics reporter, BBC News, Cleveland, Ohio
The sudden tightening of credit on high-risk sub-prime mortgages has led to a property price crash in the US, with devastating effects on the whole economy. The unprecedented decline in US house prices may also lead to further pain for financial institutions, who collectively own more than $1 trillion worth of sub-prime debt. This is the first time we have had an absolute decline in housing prices in the US since the Great Depression Richard Syron Chairman, Freddie Mac One of those who has been hard-hit by the sudden change in the housing market is Suzi Savino, a real estate agent in the pleasant suburb of Westlake, to the west of the city of Cleveland, Ohio. Real estate agents are independent professionals who get paid a fee for each house they sell. During the housing boom, Suzi earned a six-figure income, which helped pay for the good things in life, such as a home in an upscale neighbourhood and a nice car. But this year, Suzi's earnings are down by 70% - and houses are just not selling.
17 The situation is so bad that she is thinking of leaving the industry - but she would have to sell a house she owns (and inherited from her mother) in order to make up the loss of family income. The ongoing housing correction... will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet Hank Paulson, US Treasury Secretary Sitting around her kitchen table for coffee, a group of real estate agents and mortgage brokers in the area were clear what was to blame. They said that the wave of foreclosures and evictions of people who had sub-prime mortgages was having a chilling effect on the housing market - and those foreclosures had now spread from the inner city to suburbs such as Westlake. Vaughn Martin, her boss at Remax, says that he has to work twice as hard just to keep his head above water. With a huge inventory of unsold homes on his books, his clients are asking to see 30 or 40 properties, and if the buyers do not accept their offers, walking away rather than negotiating. House price crash Housing markets are local, and few areas have experienced the 30% decline in average house prices that has hit Cleveland, the sub-prime capital of the US. But average house prices across the US are declining for the first time since the Great Depression in the 1930s, and the magnitude of the collapse has surprised experts. There is nearly a year's supply of unsold houses standing vacant. SUB-PRIME CRISIS SERIES Why bad US home loans are affecting us all Next week: Financial meltdown
And the housing crash is now extending to the formerly "hot" housing markets in Southern California, Arizona, Nevada and Florida, where expanding populations and a strong economy were expected to keep prices high. Mark Zandi, an economist at Moody's, who is tracking the housing market, expects the fall in house prices to accelerate from 5% this year to 10% in 2008. He says that prices could end up 10-15% lower than the peak of 2006 - if policymakers move quickly to stem the wave of foreclosures.
18 But if they don't, and if interest rates are forced up by the inflationary worries, he says prices could fall by 15% to 20%. Mr Zandi says there are three factors that have caused the property crash:
speculative purchase of homes in hot areas by investors who intended to "flip" them, reselling quickly at a profit; the availability of easy credit, where mortgages were granted to people who could not really afford them; and the over-supply of new houses by builders.
House building industry in retreat The devastating effect of a property crash is taking its toll right across the building industry. And nowhere is the pain more evident than among house builders. At the National Association of Home Builders annual construction industry forecast conference, no one was enjoying the fancy lunch their organisation had put on. Instead, their ashen faces showed that they had only just grasped how serious the overall situation had become. The NAHB's chief economist, David Sieders, had just told them that house building would contract by 50% in the next two years, cutting employment by 1-2 million jobs and wiping out many firms - and he fears that prices might not start rising again until 2010. John Regan is a medium-size builder in the Washington DC area who has just completed a high-end condominium project in the upscale suburb of McLean, Virginia. But he has only sold a few of the 20 units in his development, and he faces huge carrying costs to pay for the money he has borrowed from the bank to finance the development. He reckons that - by putting all his life savings into the pot - he and his partner have enough cash to hold out for a year before they will go bankrupt. Ironically, one of the few people who bought one of his $1m apartments was a director of the World Bank - who drove a very hard bargain, as someone only too aware of the distress in the housing market. Mr Regan faces another problem. Unlike the large builders, he cannot afford to offer deep discounts or he won't make any profit. In the DC area, big builders are offering up to 30% discounts on their fancy homes.
19 Much of the US house building industry, however, is now dominated by large-scale builders, such as Toll Brothers or DR Horton, which are listed companies. They have been forced to cut the prices of their new homes by as much as 30%, unloading property at any price to avoid bankruptcy. And this is further depressing housing prices, especially in the "hot" areas where the big builders had concentrated their efforts. Cleveland survivor One smaller builder who looks set to survive the turmoil in the industry is Enzo Perfetto, who builds custom-built homes in the eastern suburbs of Cleveland. Mr Perfetto has two advantages: he only builds a home when a customer orders a home, and thus is not carrying an inventory of unsold houses that he has to finance; and in Cleveland, house prices were too low to attract the large house building companies as rivals. But nevertheless his business is down, from about 30 houses a year to between 20 and 25 this year. Small builders like him are also cushioned by the fact that they employ all their labour on a contract basis, getting up to 70 different crews in to build each home, employing several hundred people for a few months. But it also means that they can shed labour more easily in a downturn - adding to unemployment. Mortgage freeze The biggest problem that is likely to drive house prices down further is the complete breakdown of the system of mortgage finance in the US. During the last decade, financial institutions shifted from directly providing their customers' mortgages to relying on the credit markets for financing - similar to the system employed by the Northern Rock in the UK. By 2006, 70% of US mortgages were financed in this way. But in August, the credit markets suddenly woke up to the fact that many of the mortgage-backed securities they were being sold by the banks were much more risky than they had realised. They were worried that nearly half of all those with sub-prime mortgages were behind on their payments, and one in five are expected to go into foreclosure - thus putting their investments at risk.
20 And so they have stopped buying mortgage-backed securities altogether, unless they are backed by the government, causing the supply of mortgages to dry up. The housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest Ben Bernanke, Chairman, Federal Reserve The result is that many banks are unable to originate mortgages because they are unable to sell them on, and there has been a sharp tightening of credit all around. The majority of lenders are now tightening up conditions for prime as well as sub-prime lending, with higher deposits, a better credit score, a higher income-to-loan ratio and a lower loan-to-value ratio being demanded. TYPES OF US MORTGAGES Sub-prime: at a higher rate of interest for people with poor credit history and low income Alt-A: at a higher rate of interest for people with poor credit history but better jobs Jumbo : mortgages over $417,000 and not backed by government guarantee Prime: mortgages under $417,000 backed by government guarantee with stricter loan conditions (also called 'conforming') And it looks like the tightening is spreading to personal loans and commercial property loans. The head of Freddie Mac, the federally-sponsored agency that also lends on the wholesale mortgage market, is in no doubt how serious a crisis this is. "This is the first time we have had an absolute decline in housing prices in the US since the Great Depression and it's the first time we have had this kind of impact on the housing market without it being driven by macro-economic declines," Dick Syron told the BBC. He said that the secondary market for all non-conforming mortgages (ie those not guaranteed by Freddie Mac or other government sponsored agencies) had viritually dried. up. Economic downturn How will the property crash hurt the overall US economy, the biggest in the world, which last quarter was growing at an annual rate of 3.9%? The US Treasury Secretary, Hank Paulson, acknowledges: "The ongoing housing correction is not ending as quickly as it might have appeared late last year.
21 "And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet." The US government and the Federal Reserve believe that the housing slump, on its own, will cut US growth by 1% to 1.5%, slowing the economy to around 2.5% next year - a view currently shared by the IMF. But there is considerable uncertainty whether the economy will revive in the second half of 2008. A full-blown credit crunch, in which consumers stop spending on other items, would be much more serious. The US consumer boom has financed by credit and also helped by a significant amount of equity withdrawal, where people get cash for spending by remortgaging. This peaked at $850bn in 2006, or 7% of consumer spending. The key question is whether consumers will stop spending when they discover that their house is worth less than they thought. The former boss of the Fed, Alan Greenspan, told the BBC that there was a 30-40% chance of a full-blown recession when people realise how bad the housing situation is, and that Fed studies had shown there was a very real - but delayed - wealth effect. Others, such as Merrill Lynch, put the chances of an absolute decline in the economy, at above 50%. So there is a wide divergence of views among economists as to whether the US economy will recover in the second half of 2008. Bernanke's dilemma Much will depend on the actions of Mr Greenspan's successor at the Fed, Ben Bernanke. The Fed moved quickly to cut interest rates by 0.5% in September and made another 0.25% rate cut in October. As Mr Bernanke explained, there was a risk that "the housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest. "By doing more sooner, [the Fed] might be able to forestall some of the potential adverse effects of the disruption in financial markets."
22 However, there are signs that Fed governors are split over the wisdom of further rate cuts, and some want to take back the cuts they have already made, as the worries about the effect of higher oil prices on inflation grow. If that were to happen, says Mark Zandi, the consequences for the housing market could be severe, with price declines of up to 30% in some areas. And that, in turn, would multiply the losses in the financial sector. So Wall Street, at least, is still betting on further rate cuts to save the day. Story from BBC NEWS: Is the credit crunch finally over? It has been a dramatic week on the financial markets, with the US central bank cutting interest rates and the UK government coming to the rescue of savers at the Northern Rock. So is the crisis over, or are there still some big problems remaining? WHERE'S THE BAD DEBT? The crisis began when US mortgage companies made hundreds of billions of dollars of inappropriate loans to individuals with poor credit histories. These debts were then packaged up and sold to financial institutions around the world, who then sold it on to pension funds and hedge funds. We still don't know where these bad debts are concealed in the financial system. And until we do, banks will still be reluctant to lend to each other, and investors will be suspicious of the health of the financial sector. UNFREEZING THE CREDIT CRUNCH The reluctance by banks and other financial institutions to lend money, because they are not sure how risky it might be, is gumming up the financial system. Despite the injection of hundreds of billions of dollars and euros, interest rates on interbank lending are still unusually high. And banks are tightening up on their lending to individuals and companies, restricting the amount of lending as well as making loans more expensive. There are also hundreds of billions of dollars worth of short-term debt obligations that will fall due in the next six months, which could further depress the market if no buyers can be found for them.
23 WILL THE HOUSING MARKET CRASH? The overhang of bad mortgages is depressing the US housing market. Thousands of people are having their homes repossessed, and with a glut of homes on the market prices are dropping. Mortgage companies are finding it difficult to raise money even to lend to sound borrowers. So despite a pledge by the US government to help, house building is at a record low. Although there are far fewer sub-prime mortgages in the UK, mortgage lenders like Northern Rock are also finding it difficult to raise the cash to pay for additional mortgage lending. So it could become harder to get a mortgage, and it could cost more - and both these expectations are lowering house price inflation. WILL THERE BE A WORLD RECESSION? A big slowdown in the housing market could have serious economic consequences. Construction is a big part of the economy, and people who move house are also more likely to buy consumer goods like washing machines. The tightening up of credit and worries about mortgage repayments may make everyone more nervous about borrowing money to buy big-ticket items like cars. There are already signs of an economic slowdown in the US, the world's biggest economy. And if it deepens, it could dampen down the economic recovery underway in Europe and Japan. The UK, as a major exporting nation, would also be affected. WILL THE DOLLAR PLUMMET? The effect on the rest of the world economy could be worse if the US dollar begins to fall in value. The dollar is already weak because of the huge trade deficit the US runs with the rest of the world - nearly $1 trillion - which has been a big boost to the world economy. But if the US economy slows, and interest rates are cut sharply, the dollar will become a less attractive currency and could fall further. This in turn would make imports into the US more expensive, and make it harder for exporters like Britain to win orders. A big decline could also force countries like China, which hold $1.3 trillion in currency reserves, mainly in dollars, to diversify their holdings, further depressing the greenback. WHO'S TO BLAME?
24 Politicians and financial institutions are trading accusations about who is to blame for the crisis. In the UK, the governor of the Bank of England is under fire for not intervening earlier to prevent the Northern Rock crisis from getting out of hand. In the US, the central bank, the Federal Reserve, is under fire in Congress for not regulating sub-prime mortgage lending properly. And both bankers and politicians have blamed the credit rating agencies for certifying as safe many of the bad debts which had been bundled up and sold. There is a growing move to tighten up international regulation of the financial sector - but worries about whether this can be done without inhibiting financial innovation. IS THERE A SILVER LINING? Many economists believe that the crisis is also an opportunity for rebalancing the economy, which has become overly dependent on consumer spending financed by cheap credit and government borrowing. An increase in household savings, encouraged by higher interest rates for savers, could lead to more long-term investment. And a mild economic slowdown in the US, coupled with a gradual reduction in the value of the dollar, could help rebalance the world economy, which has become overly dependent on the US as the engine of world economic growth. Story from BBC NEWS: Sorting out the sub-prime problem By Steve Schifferes Economics reporter, BBC News, Washington DC
On 31 August, President George W Bush appeared in the White House Rose Garden to urge action to deal with a serious crisis in the US economy. He was flanked by two of the most powerful players in the global economy: US Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke. The sub-prime crisis - which is threatening millions of families in the US with eviction, has created turmoil in the financial markets, and lead to serious disruption to the US economy and housing market - had moved to the top of the political agenda.
25 Action was required, so the Fed intervened by providing massive short-term liquidity to preserve the banking system and cut interest rates twice, the first time by half a percentage point. This was followed, perhaps belatedly, by new and tougher regulation of the mortgage industry, with new limits on sub-prime "balloon" mortgages, whose payments are fixed for 2 years and then rise sharply to a much higher variable rate. Recent disturbances in the sub-prime mortgage industry are modest in relation to the size of our economy President George W Bush
Both the Bush administration and the Democrats, which control both Houses of Congress, have been searching for bipartisan solutions that will solve the crisis and provide help to the millions of people - including many victims of predatory lending now facing eviction. But deep ideological divisions between the two sides - with the Democrats favouring much tighter regulation of the industry, and the Bush administration looking to private sector solutions - is hampering attempts to reach an early resolution of the problem. And the two sides also disagree on how severe an impact the crisis will have on the US economy. Stopping foreclosures The most urgent problem is to help the millions of homeowners who were sold "balloon" sub-prime mortgages in the past two years, whose interest rates are now set to double, leading to evictions and repossessions - known as foreclosures in the US. The Bush administration's point man on this issue, Treasury Under Secretary Robert Steel, says he focuses on this issue every day. "Our role is to ensure that lenders and servicers are being flexible with regard to working with the borrowers," he says in an interview with BBC News. Our role is to ensure that lenders and servicers are being flexible with regard to working with the borrowers Robert Steel, US Treasury Under Secretary for Domestic Finance
The Treasury plan is to bring together lenders and borrowers to work out individual voluntary agreements to avoid foreclosure.
26 It has created a joint private-public task force, Operation Hope (Home owner protection effort), to encourage lenders to take a softer line, whilst also urging borrowers to tell lenders earlier when they run into financial difficulties. Yet less than 1% of sub-prime mortgages are successfully renegotiated. Many housing aid agencies say it is impossible for lenders to individually renegotiate the "tidal wave" of troubled mortgages in time to stop foreclosures. The Fed estimates that every three months, 450,000 families will face sharply higher mortgage rates over the next two years. They have urged mortgage pools and mortgage servicers to "pursue loss mitigation strategies that preserve home ownership" and to contact borrowers before mortgages go up. And they are urging a more uniform approach among the lenders on which borrowers will qualify for relief from foreclosure. The most radical proposal has come from an unlikely source. Sheila Bair, the head of the Federal Deposit Insurance Corporation, which regulates bank deposits, has suggested a complete freeze on any interest rate increase on these "ballon" mortgages, as long as the mortgage-holder is not already in arrears on his payments. But she has faced fierce criticism from the mortgage industry, which believes that this would create what economists describe as "moral hazard" - with people who bought more insecure mortgages getting better protection from eviction than people with ordinary mortgages - and thus encouraging people to get more risky mortgages in the future. Reviving the mortgage markets The sub-prime crisis has paralysed the mortgage-lending industry, as bondholders are loath to buy mortgage-backed securities unless they are guaranteed by the government.
This has made much more difficult for individuals to get mortgages if they do not qualify for "prime" mortgages funded by the government-sponsored Freddie Mac and other mortgage agencies. This includes well-off borrowers who want "jumbo mortgages" over $417,000 (£204,000), as well as borrowers with weak credit histories. In all, this includes about a third of all borrowers.
27 The Democrats, and Freddie Mac itself, say that a quick way to help ease the situation would be to temporarily expand the role of these agencies. TYPES OF US MORTGAGES Sub-prime: at a higher rate of interest for people with poor credit history and low income Alt-A: at a higher rate of interest for people with poor credit history but better jobs Jumbo : mortgages over $417,000 and not backed by government guarantee Prime: mortgages under $417,000 backed by government guarantee with stricter loan conditions (also called 'conforming') They want the government to raise the limit on the maximum size of the mortgages they can insure to $1m, and they want a big increase in the cap that limits the total amount they can provide to the mortgage-backed securities market. But these agencies have had a troubled recent history, and have been recently put under tighter regulation to correct abuses. The Bush administration is reluctant, therefore, to give them a bigger role in the mortgage market. The commercial banks are also against any expansion of the their role, which they say would make the private label mortgage-backed securities market less attractive. Regulating mortgage brokers The debate over what long-term changes should be made in the mortgage regulatory system to eliminate the lending abuses of the past decade has proven quite difficult to resolve. The problem is a fight between state and Federal regulators over who should have the main responsibility. States that have now recognised the problem, for instance Ohio, are worried that the Federal government will opt for the lowest common denominator, and thus introduce standards that are lower than those they have now introduced. The mortgage industry, on the other hand, would like a uniform national standard, so that it does not have to deal with a multitude of conflicting state regulations. One compromise - crafted by Barney Frank, chairman of the House Financial Services Committee - would set a minimum Federal standard of good practice, but allow states to go further if they want. And the House of Representatives has moved swiftly to pass Mr Frank's bill, which was only introduced in October.
28 It was approved on 15 November by a lopsided vote of 291 - 127, with many Republicans from Northern states hit by the sub-prime crisis breaking ranks to support the measure. However, Republicans in both the Senate and the White House are warning that the bill goes too far in interfering with mortgage markets, and may make it harder for poor people to get loans in the future. Restructuring the credit markets One of the provisions of the bill that has been most strongly opposed by the mortgage industry gives home owners the right to sue the banks who securitised their loans if they did not carry out due diligence in checking that the loans were sold honestly. Supporters say this is the only way to force the banks that no longer own the mortgages to check them properly, and point out that it limits the damages to the amount of the loan itself, and prevents lawsuits reaching the bondholders who own the mortgages. Democrats like Maxine Waters, who represents South-Central Los Angeles, have warned the industry to expect even tougher regulation if they do not take more action to stop foreclosures. But critics of regulation, such as the American Enterprise Institute, argue that any attempt to regulate the $6 trillion mortgage bond market will only have a chilling effect, limiting the availability of mortgages for ordinary people. But even some conservatives say that the industry as currently structured creates too big a gap between the ultimate owners of mortgages - bondholders around the world - and the mortgage banks who originated the loans. One proposal, from the former deputy chairman of the Fed, Roger Ferguson, and some European regulators, is to require banks who securitize mortgages to retain a partial equity stake in the loan, to encourage them to scrutinise more carefully whether the mortgages are sound. There is also strong pressure to regulate the rating agencies, which gave these investments their seal of approval - and perhaps change the current system in which they are paid by the banks issuing the mortgage bonds, not the investors. Bailing out investors In the last big banking crisis in the US, when thousands of savings and loan banks went bankrupt after deregulation, the cost to the taxpayer was $150bn - $200bn.
29 With the Federal budget in deficit, no one at the moment wants to bail out either the banks or the investors who bought these complex and now largely worthless securities, or the borrowers who took out the loans. Democrats argue that Wall Street should take some of the blame, and therefore financial pain, for the debacle. Republicans argue that everyone must bear individual responsibility for their bad decisions, and any bail-out would merely encourage banks and individuals to do the same thing again. However, as the crisis intensifies, and a wave of evictions sweeps America, it may be that tougher laws - and perhaps a compulsory freeze on "balloon" mortgage resets - emerge during the 2008 presidential election year. Story from BBC NEWS: Sorting out the sub-prime problem By Steve Schifferes Economics reporter, BBC News, Washington DC
On 31 August, President George W Bush appeared in the White House Rose Garden to urge action to deal with a serious crisis in the US economy. He was flanked by two of the most powerful players in the global economy: US Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke. The sub-prime crisis - which is threatening millions of families in the US with eviction, has created turmoil in the financial markets, and lead to serious disruption to the US economy and housing market - had moved to the top of the political agenda. Action was required, so the Fed intervened by providing massive short-term liquidity to preserve the banking system and cut interest rates twice, the first time by half a percentage point. This was followed, perhaps belatedly, by new and tougher regulation of the mortgage industry, with new limits on sub-prime "balloon" mortgages, whose payments are fixed for 2 years and then rise sharply to a much higher variable rate. Recent disturbances in the sub-prime mortgage industry are modest in relation to the size of our economy President George W Bush
30
Both the Bush administration and the Democrats, which control both Houses of Congress, have been searching for bipartisan solutions that will solve the crisis and provide help to the millions of people - including many victims of predatory lending now facing eviction. But deep ideological divisions between the two sides - with the Democrats favouring much tighter regulation of the industry, and the Bush administration looking to private sector solutions - is hampering attempts to reach an early resolution of the problem. And the two sides also disagree on how severe an impact the crisis will have on the US economy. Stopping foreclosures The most urgent problem is to help the millions of homeowners who were sold "balloon" sub-prime mortgages in the past two years, whose interest rates are now set to double, leading to evictions and repossessions - known as foreclosures in the US. The Bush administration's point man on this issue, Treasury Under Secretary Robert Steel, says he focuses on this issue every day. "Our role is to ensure that lenders and servicers are being flexible with regard to working with the borrowers," he says in an interview with BBC News. Our role is to ensure that lenders and servicers are being flexible with regard to working with the borrowers Robert Steel, US Treasury Under Secretary for Domestic Finance
The Treasury plan is to bring together lenders and borrowers to work out individual voluntary agreements to avoid foreclosure. It has created a joint private-public task force, Operation Hope (Home owner protection effort), to encourage lenders to take a softer line, whilst also urging borrowers to tell lenders earlier when they run into financial difficulties. Yet less than 1% of sub-prime mortgages are successfully renegotiated. Many housing aid agencies say it is impossible for lenders to individually renegotiate the "tidal wave" of troubled mortgages in time to stop foreclosures. The Fed estimates that every three months, 450,000 families will face sharply higher mortgage rates over the next two years.
31 They have urged mortgage pools and mortgage servicers to "pursue loss mitigation strategies that preserve home ownership" and to contact borrowers before mortgages go up. And they are urging a more uniform approach among the lenders on which borrowers will qualify for relief from foreclosure. The most radical proposal has come from an unlikely source. Sheila Bair, the head of the Federal Deposit Insurance Corporation, which regulates bank deposits, has suggested a complete freeze on any interest rate increase on these "ballon" mortgages, as long as the mortgage-holder is not already in arrears on his payments. But she has faced fierce criticism from the mortgage industry, which believes that this would create what economists describe as "moral hazard" - with people who bought more insecure mortgages getting better protection from eviction than people with ordinary mortgages - and thus encouraging people to get more risky mortgages in the future. Reviving the mortgage markets The sub-prime crisis has paralysed the mortgage-lending industry, as bondholders are loath to buy mortgage-backed securities unless they are guaranteed by the government.
This has made much more difficult for individuals to get mortgages if they do not qualify for "prime" mortgages funded by the government-sponsored Freddie Mac and other mortgage agencies. This includes well-off borrowers who want "jumbo mortgages" over $417,000 (£204,000), as well as borrowers with weak credit histories. In all, this includes about a third of all borrowers. The Democrats, and Freddie Mac itself, say that a quick way to help ease the situation would be to temporarily expand the role of these agencies. TYPES OF US MORTGAGES Sub-prime: at a higher rate of interest for people with poor credit history and low income Alt-A: at a higher rate of interest for people with poor credit history but better jobs Jumbo : mortgages over $417,000 and not backed by government guarantee Prime: mortgages under $417,000 backed by government guarantee with stricter loan conditions (also called 'conforming')
32 They want the government to raise the limit on the maximum size of the mortgages they can insure to $1m, and they want a big increase in the cap that limits the total amount they can provide to the mortgage-backed securities market. But these agencies have had a troubled recent history, and have been recently put under tighter regulation to correct abuses. The Bush administration is reluctant, therefore, to give them a bigger role in the mortgage market. The commercial banks are also against any expansion of the their role, which they say would make the private label mortgage-backed securities market less attractive. Regulating mortgage brokers The debate over what long-term changes should be made in the mortgage regulatory system to eliminate the lending abuses of the past decade has proven quite difficult to resolve. The problem is a fight between state and Federal regulators over who should have the main responsibility. States that have now recognised the problem, for instance Ohio, are worried that the Federal government will opt for the lowest common denominator, and thus introduce standards that are lower than those they have now introduced. The mortgage industry, on the other hand, would like a uniform national standard, so that it does not have to deal with a multitude of conflicting state regulations. One compromise - crafted by Barney Frank, chairman of the House Financial Services Committee - would set a minimum Federal standard of good practice, but allow states to go further if they want. And the House of Representatives has moved swiftly to pass Mr Frank's bill, which was only introduced in October. It was approved on 15 November by a lopsided vote of 291 - 127, with many Republicans from Northern states hit by the sub-prime crisis breaking ranks to support the measure. However, Republicans in both the Senate and the White House are warning that the bill goes too far in interfering with mortgage markets, and may make it harder for poor people to get loans in the future. Restructuring the credit markets
33 One of the provisions of the bill that has been most strongly opposed by the mortgage industry gives home owners the right to sue the banks who securitised their loans if they did not carry out due diligence in checking that the loans were sold honestly. Supporters say this is the only way to force the banks that no longer own the mortgages to check them properly, and point out that it limits the damages to the amount of the loan itself, and prevents lawsuits reaching the bondholders who own the mortgages. Democrats like Maxine Waters, who represents South-Central Los Angeles, have warned the industry to expect even tougher regulation if they do not take more action to stop foreclosures. But critics of regulation, such as the American Enterprise Institute, argue that any attempt to regulate the $6 trillion mortgage bond market will only have a chilling effect, limiting the availability of mortgages for ordinary people. But even some conservatives say that the industry as currently structured creates too big a gap between the ultimate owners of mortgages - bondholders around the world - and the mortgage banks who originated the loans. One proposal, from the former deputy chairman of the Fed, Roger Ferguson, and some European regulators, is to require banks who securitize mortgages to retain a partial equity stake in the loan, to encourage them to scrutinise more carefully whether the mortgages are sound. There is also strong pressure to regulate the rating agencies, which gave these investments their seal of approval - and perhaps change the current system in which they are paid by the banks issuing the mortgage bonds, not the investors. Bailing out investors In the last big banking crisis in the US, when thousands of savings and loan banks went bankrupt after deregulation, the cost to the taxpayer was $150bn - $200bn. With the Federal budget in deficit, no one at the moment wants to bail out either the banks or the investors who bought these complex and now largely worthless securities, or the borrowers who took out the loans. Democrats argue that Wall Street should take some of the blame, and therefore financial pain, for the debacle. Republicans argue that everyone must bear individual responsibility for their bad decisions, and any bail-out would merely encourage banks and individuals to do the same thing again.
34 However, as the crisis intensifies, and a wave of evictions sweeps America, it may be that tougher laws - and perhaps a compulsory freeze on "balloon" mortgage resets - emerge during the 2008 presidential election year. Story from BBC NEWS: Mr King has said that targeting inflation is a priority for the Bank King on slowdown The governor of the Bank of England, Mervyn King, has warned that the UK economy faces its toughest challenges since 1997. The UK faced "a period of above-target inflation and a marked slowing in growth", he told business leaders. Mr King spoke after the US Federal Reserve slashed interest rates to 3.5% from 4.25% in a surprise move that saw global markets recover some ground. His comments suggest that UK rates will not come down by much, say analysts. 2008 is likely to see higher energy prices, higher food prices and higher import prices Mervyn King, Bank of England chief BBC business editor Robert Peston said that Mr King's speech to Institute of Directors members in Bristol was the gloomiest he had heard from the Bank of England governor. "It means it's going to be a pretty difficult year with slowing economic growth, unemployment rising but the cost of money not coming down as much as businesses and consumers would like," he said. Balancing act The Bank of England's rate-setting Monetary Policy Committee will meet on the 6 and 7 February to decide on the direction of interest rates from their current level of 5.5%. It confirmed it would not be making a decision before that, as the US central bank, the Fed, did on Tuesday to bolster confidence in the US economy, which is the world's largest. Many analysts expect a rate cut at the MPC's next meeting, but Mr King's inflation concerns will prevent the Bank from making as dramatic a reduction over the coming months as the US has done. He warned that "2008 is likely to see higher energy prices, higher food prices and, with a lower exchange rate, higher import prices, pushing inflation above the 2% target".
35 And he said he thought it was "possible" that consumer price inflation - measured by the Consumer Price Index (CPI) - would rise to 3% or more. This would mean he would need to write a letter of explanation to the Treasury, possibly on more than one occasion. Mr King is obliged to inform the government in a letter when inflation is more than one percentage point above the government's inflation target of 2%. Expensive borrowing costs On the other hand, Mr King warned that problems in the banking sector relating to huge losses as a result of soured investments in US sub-prime home loans mean businesses and consumers would face higher borrowing costs for the foreseeable future. "It is likely that a less buoyant housing market will go hand-in-hand with slower growth of consumer spending," he said. "Tighter credit conditions mean that, as a nation, we are likely to save more of our income this year than in the recent past. "In the short run, that will slow economic activity, possibly quite sharply. And there is a risk that weaker activity and lower asset prices could result in another round of losses for banks and a further tightening of credit conditions." +++++++++++++++ Q&A: Stock market falls Global stock markets are into their second day of hefty falls. On Monday, European markets suffered their most severe falls since the attacks of 11 September 2001. Why have they suddenly been falling so sharply and can anything stop them? What has kicked off these falls? Stock market investors around the world are very worried about the state of the US economy. Some US banks have decided that their economy is already in recession or are predicting that it will be soon. There were high hopes that a stimulus package announced by President George W Bush would give everyone a lift last Friday, but in the event, it was disappointing.
36 Why does everyone care about the US economy so much? US consumers and businesses are big customers for almost every country. So far, some stock markets such as the Shanghai Stock Exchange had appeared immune to the US economy, but its main index has now lost 17% in six trading days. Even if the US is not your biggest customer, a recession there would be bad news for your other trading partners and the knock-on effects would hit almost everybody. What has gone wrong in the US? All of the problems were kicked off by record levels of defaults on sub-prime mortgages in the US. Sub-prime mortgages are offered to people with inferior credit records or unpredictable incomes. It turned out that US lenders had been repackaging the debt and selling it to banks worldwide. The default levels meant that the repackaged debt was of questionable value. Suddenly, banks worldwide were reluctant to lend money to each other, because they did not know which banks were creditworthy any more and they were not sure how much of their own money they could afford to lend. This became known as the credit crunch and it has made it harder for banks, companies and consumers to borrow money. But we have known this for ages, haven't we? We have, but nobody knows how severe the slowdown will be or whether there will be a recession in the US. After President Bush's stimulus package turned out to be a disappointment, there were also signs that the US downturn was having an even greater effect worldwide than had been thought. It was reported on Monday that Bank of China was about to announce huge write-downs, or losses, from investments linked to US sub-prime mortgages. On Tuesday, the bank's shares were suspended ahead of an announcement. Write-downs happen when a company says that something it owns is worth less than it had previously thought.
37 Also on Monday, Germany's WestLB said it expected a net loss of one billion euros ($1.4bn; £740m) because of its sub-prime exposure. What can stop the falls? That's a tricky one. The US central bank has been cutting interest rates and on Tuesday slashed its main borrowing cost to 3.5% from 4.25% in a shock move aimed at shoring up investor sentiment. At the same time, President Bush has proposed big tax relief plans. None of that seems to have convinced investors that a US recession can be avoided, with huge consequences for the global economy. The big question is whether we are just seeing a bad month for shares - or whether this is the start of a bear market that could see share prices sliding for years. Officially, a bear market is one in which shares are trading 20% below their highs. Some major stock markets are already bear markets and many others are close to that stage. Why should I care? If there is a US recession and it triggers a global slowdown, then everybody will feel its effects. Jobs will be less secure and many people will have more difficulty borrowing money for things such as house purchases. As for the stock market falls, Monday's declines brought about the biggest widening of the deficits of UK pension schemes since they introduced the current way of calculating them in 2001. So if you are saving for a pension, these falls could eventually leave you with less to retire on. Also, you can look at share prices as a prediction that companies are going to make smaller profits this year. If companies make less money, they pay less tax to the government, which must then either cut its spending or look for other sources of funding. And that could hit you in the pocket.
38 Story from BBC NEWS: +++++++++++++++++++++++ Booms and busts on the UK market BLACK MONDAY, 19 OCTOBER 1987 The stock market had been soaring for six years and there was a growing fear that shares were overpriced. The downturn, though, was more violent than anyone expected. Stocks slumped 9.1% on Monday and then plunged 11.4% on Tuesday. Analysts blamed it on "portfolio insurance", a new trading strategy that failed to work, which prompted panic among investors. INTEREST RATES SOAR, AUGUST - SEPTEMBER 1992 The market plunged as the government attempted to keep the British pound in the European Exchange Rate Mechanism (ERM). The chancellor increased interest rates to 15% and the stock market slumped. But the efforts were in vain. The government was forced to abandon the ERM on 16 September 1992. HEDGE FUND COLLAPSES, RUSSIA CRISIS, JULY - OCTOBER 1998 Long Term Capital Management (LTCM) was supposed to be the investment fund that could not fail. The brains behind it included two Nobel prizewinners. Unfortunately for them, the Asian financial crisis in 1997 destroyed the fund's investment model. LTCM's borrowing threatened the stability of the US banking system. Investors panicked and an emergency bailout had to be arranged. The market was further upset by Russia's financial crisis and its refusal to pay interest on government debt. DOTCOM BUST, MARCH 2000 - 2003 During the dotcom boom, many investors were persuaded that profits did not matter.
39 Internet-based firms with no proven track record raised millions of pounds by selling shares. Big European phone companies spent billions of dollars on hi-tech, or 3G, phone licences. Technology stocks hit a peak in March 2000 and investors began to sober up. From that peak, the market dropped more than 50%, touching bottom in 2003. TWIN TOWERS ATTACKED, 11 SEPTEMBER 2001 The attacks in New York and on the Pentagon triggered huge losses for shares in London. The FTSE 100 index fell 5.7%, still the fourth-biggest one-day loss. CREDIT BOOM, 2003 - 2007 The UK economy enjoyed four years of healthy growth, helped by a strong performance in the US and the rise of India and China. Low interest rates fuelled a surge in property prices, encouraging consumers to go out and spend. The financial services industry in the UK also boomed and London challenged New York as the world's financial capital. SUB-PRIME BUST, JANUARY 2008 The US property market went into a slump, prompting fears that the US economy might be heading into recession. It also emerged that US banks had made huge losses on investments backed by mortgages made to homeowners with poor credit histories, known as "sub-prime" loans. Those fears reached a peak on 21 January 2008, resulting in a 5.5% slump for the FTSE 100 index, its worst one-day fall in more than six years. Story from BBC NEWS: ++++++++++++++++++