From Subprime to Stock Swoon
This whole downward spiral seemed to start with U.S. subprime mortgages. What exactly are they?Subprime mortgages are home loans made to people who would not, under normal circumstances, be ideal candidates to get a mortgage - thus they are “subprime.” These are individuals who have a higher risk of defaulting on their loan, such as those who have been delinquent in making payments in the past, or people with a bankruptcy on their credit record, or those who simply don’t have a credit history.
Starting around 2005, U.S. lenders loosened their rules and began granting mortgages to borrowers who provided very little evidence of their income and ability to repay. Many of these mortgages had very low initial interest rates, for the first six months to three years, but when that period ended the payments jumped sharply. Borrowers were led to believe that they would be able to refinance their homes at this point because the value of the property would have increased. But the slump in the housing market meant that didn’t happen. As a result many people - especially those who had not been completely frank about their income levels - defaulted on their mortgages and lost their homes.What is the “money market,” and why does it matter if it freezes?The money market is made up short-term loans (generally of less than one year), such as certificates of deposit, commercial paper, banker’s acceptances, and 30-day treasury bills.
If the money market freezes up - in other words, no one wants to make short-term loans because they are worried about borrowers defaulting - companies cannot get the cash they need to pay staff, buy supplies, or pay rent. Often companies need to borrow this money because they are waiting for revenue that may not arrive for a few days or weeks.
But if they can’t get short-term cash from the money markets, it can make day-to-day operations very difficult. If our banking system and mortgage lending practices are more stable than in the U.S., why do the Canadian dollar and TSX continue to go down?The precipitous drop in the stock markets now seems to have little to do with fundamentals. It is tied to the fear and panic gripping investors. People appear to think the world is going to move into a broad recession, and companies are going to suffer as a result. If the U.S. economy shrinks because of the credit crisis it will inevitably hurt Canadian firms who export across the border. And while our banks seem to be strong, they too are having trouble getting - and giving - short-term credit, which could slow growth of companies here.
The Canadian dollar is likely reacting to the fall in crude oil and commodity prices. As Philips, Hager & North’s chief economist Patricia Croft noted, the loonie is still regarded on world markets as something of a “petro-currency.”
What is the problem with the banks in Europe, since they haven’t had a subprime mortgage crisis?Some European banks have U.S. operations that have been hit by the subprime crisis, while others have assets backed by U.S. mortgages. At the same time, the real estate market in some European countries has been depressed because of worries over a recession, and this has damaged mortgage lenders. On top of all this, many big European banks operate in several countries, but there is no pan-European rescue package that can be used to help them out if they are in danger of failing and their home-country governments aren’t up to the task. Do interest rate cuts actually help boost the stock market?In theory, they should. If an investor is trying to make a decision between putting money into a bond or a stock, he or she will look at the difference between the yield on the bond and the possible return on the stock. Bond yields should fall when interest rates go down, making stocks more attractive. Essentially, for a stock to compete for an investor’s money, it doesn’t need to offer as high a rate of return.
However, bond yields do not always follow central bank interest rate cuts, and they haven’t this time. Some very high-quality corporate bonds, for example, are offering huge yields compared with the stock market.
While lower interest rates should also make corporate borrowing easier and thus lower costs and finance growth, that hasn’t been happening either in the current credit crunch.
On top of all this, worries over a recession or panic over falling stocks can trump any minor tweaking of interest rates.
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WHAT ARE FANNIE MAE AND FREDDIE MAC? WHY THE CUTE NAMES?
Fannie Mae is the nickname of the Federal National Mortgage Association, while Freddie Mac is the Federal Home Loan Mortgage Corp.
Fannie Mae is the older of the two. It was created as a government agency in 1938 under U.S. president Franklin Roosevelt’s New Deal. The idea was to give local banks federal money to finance home mortgages, since private lenders were leery of lending money. The government wanted to help more people buy homes, and encourage the building of affordable housing. In 1968 it became a private company.
Freddie Mac was set up in 1970 to expand the secondary mortgage market, and ensure there was competition with Fannie Mae’s monopoly. Both companies buy loans from banks or mortgage firms, and re-sell these as mortgage-backed securities. Together they own or guarantee about half of U.S. mortgages.
The two were put under “conservatorship” by the U.S. Federal Housing Finance Agency on Sept. 7 - essentially a takeover by the government.