Magazine / History / Euro / Article | 19/02/2008

A crisis spreads around the world

Oliver Stock explains how US property owners with insufficient funds are causing the world economy to falter. What kind of consequences will the crisis have in Europe?

Now that doesn't happen often: Marcel Rohner is standing up front on the undecorated podium of the large Zurich stock market hall; there where trading hasn't taken place on the parquet for a long time, and where the rooms are now used for conferences. A slim man in his early forties, looking pale. He is the boss of the largest bank in Europe, the Swiss UBS, and has just had to announce the first annual loss in the entire history of the bank. "The result is not acceptable”, he says through clenched teeth, and then hastens through the figures. By the end of this, it's clear: the once-proud bank, which emitted enough solidarity to reflect on itself and its country worldwide, has fallen. How could this happen?

Photo: AP

At the same time, beyond the Atlantic Ocean, an average American is sitting down to an evening meal with his family. Let's call him Alex Brown. He has a relatively-well paid job and no capital of any note. A full year ago, Alex Brown fulfilled his dream of buying his own house. The bank who gave him a loan didn't even want to see complicated securities. At that time, no-one was interested in that fact that Alex Brown, together with hundreds of thousands of other Americans, received a loan for his own home although his credit-worthiness was highly questionable. The only strange thing recorded by statisticians at this point was a decrease in residential construction. This is often a harbinger announcing flagging economical activity. Only when, at the end of March 2007, the financial service provider New Century Financial placed itself under creditor protection, did the term "Subprime mortgages” begin to cause pulses to rise in Europe, too. The first alarm bells rang out at the UBS in Zurich. Far too late, as it later became clear.

The UBS could have observed other signs; for example those which a recently-published study of the International Monetary fund (IMF) describes in detail. The authors realised that the volume of the new mortgage loans (a form of credit which is secured via entry into the land register) had tripled to 600 billion dollars in the USA in only seven years, between 2000 and 2006. The proportion of risky loans increased during the same time period from nine to twenty percent.

The researchers come to the conclusion that the financial politics of the US central bank Fed was responsible for this development. Fed had supplied the market for years with cheap money. Added to this, an ominous tendency of the banks to make their criteria for loan allocation dependent on market developments and not on the effective credit-worthiness of a debtor such as Alex Brown played a role. The result: the more applications were made for Subprime loans, the more the market was coveted, and the fewer checks were made on the loan. The IMF authors show the prompt increase in numbers in regions where many Subprime loans had already been granted in comparison to other regions. The reason for this, in their opinion, could be that the creditors had bet on an enduring property boom.

As long as this was all working, Alex Brown would have been "able” not to pay. The bank would have been in a position to sell the needy loan off fast. They could have put him in a package with better loans; a rating agency could have stamp-marked a "good" on it, and some consumer would have taken it on quickly. The credit-worthiness of debtors – who is interested in that, as long as everyone plays along? And everyone was playing along, because money was cheap and crying out to be invested.

As the US investment banker, Georges Soros, sums it up: every time the credit expansion got into difficulties in the last decades, the financial authorities intervened, pumping liquidity into the economy by lowering the interest. "In this way, a system was created which demanded an ever-larger credit expansion. It was so successful that people began to believe in the magic of the market”, complains Soros.

Alex Brown is discussing this result in icy tones with his family during the evening meal. The bubble has burst. The value of his house has dropped severely. According to a report from the Zillow market research institute, more than a third of all property owners who fulfilled their dream of having their own home at the beginning of 2007 are trapped in a web of debts. That means that, with an advance payment of 10 percent, the debts on the mortgage for these people have become larger than the actual value of the property.

Since then, Murphy 's Law has reigned; everything which can go wrong will go wrong. What began with Subprime mortgages spread to special bonds of debt, and endangered community insurances, mortgage insurances and reinsurance businesses, threatening to dismantle the market for Credit Default Swaps. The engagements of the investment banks for externally-financed takeovers, in which, among others, the USB was active, became liabilities. The market for claim security money market securities broke down, and rescue funds conceived by the banks to get the mortgages out of their balances could no longer gain external funding. The final straw came when the loan extensions between the banks; the heart of every financial system, was interrupted because the banks were having to economize on resources, and were unable to trust their business partners.

This was the point, if not before, at which the US crisis began to make waves on the other side of the pond. In little Austria, which no one pays much attention to as a place for banks, the great players on the financial market, who all earn their money on loans for Eastern Europe, have since then had to watch as these loans, which far exceed their capital contributions, become more and more difficult to finance.

In London, nervousness can be sensed everywhere. Whether it is stock market traders, bending over their screens, or consumers reading their last bank statement: the worry over further economic developments is written all over British faces. Credit crises, fear of recessions and global collapses in shares have immediate consequences for the finance centre on the Thames. On no other sector is Great Britain so dependent. More than half a million people work for the banks and insurances in the city. They form the economic backbone for the country. And yet after the spectacular collapse of the mortgage bank Northern Rock, an increasing number of financial institutes are experiencing problems. A wave of redundancies has already hit the city.

All at once, the British are noticing that the over-expensive property market is their Achilles heel. After the unparalleled boom during the past years, a change is in the wind. The strong increase in interest loans for building owners; difficulties in procuring mortgages and a marked drop in house prices have made many uncertain. The IMF is convinced that British property is approximately 40 % too expensive – and is liable to sink accordingly. The Royal Institute of Property Surveyors assumes that already now more than 120 families are losing their house or flat every day. The crisis has also hit the largest political economy in Europe broadside: Germany has, as one of the last EU countries, an opaque system of Federal State Banks, which stem from Germany AG. The problem is that they neither have a sustainable business model, nor do enough professionals hold positions in their boards of directors. The consequence: the Federal State Banks in particular have participated in the once smooth-running US money-making machine with Subprime papers. In the meantime, the horror scenarios which the Federal State Banks are recording in the presentations for shocked analysts are becoming more and more dramatic.

While the private banks such as the Deutscher Bank and the Commerzbank will have to support their losses with their own resources, the rescue packages for the Sachsen LB and West LB must be secured with billions of Euros from the Federal budgets. Billion-depreciations for the BayernLB threaten to encumber the Free State's budget. And without help from the Federal State, the little Düsseldorfer IKB cannot survive. And at the end of it all, the costs are carried by the tax-payer.

In Switzerland, things haven't yet come to such a pass. There, financial investors from the Middle and Far East are hurrying to lend their support, and will probably give the UBS billion-injections. The financial centre of Zurich will then look very different. The first analysts are already sitting in the café opposite the stock market, having left the sorry presentation by the UBS boss early. UBS stands for "United Banks of Switzerland”. Those outside prophesy gloomily as they empty their second cup of Espresso that, once the new investors have joined, it will stand for "United Banks of Singapore”.

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