Credit crunch. It has started to dominate our lives, though we may not – yet – have been personally crunched ourselves. The world's financial system is in chaos. Banks are being bailed out. Credit is getting harder and harder to find, even for those with squeaky-clean records. Where only a few months ago there was confidence bordering on recklessness, now there is simply fear. Where once the Royal Bank of Scotland felt confident enough to offer a shih-tzu dog in Manchester a gold credit card with a limit of £10,000, now the Royal Bank itself, like most of its peers, is finding it hard to borrow money itself.
The banks, in other words, are even fearful – especially fearful, in fact – of lending to each other. They are "hoarding liquidity", as they call it, because they can't be sure of getting their money back. No one quite knows where the bodies are buried – the ultimate size of the losses that will be suffered on devalued mortgage-backed securities tied to an American housing market that has gone into a tailspin. Indeed, because that process is yet to play out, no one can know what those losses will be. It is not a question of the banks hiding their problems – "lack of transparency" in the jargon – but of an unknowable future. Hence the all-pervading nervousness. And that means you will finder it tougher to get a mortgage or a car loan, and the company you work for will experience problems borrowing money to fund investment plans. It is pushing the world towards recession.
Few really understand it – even on Wall Street and in the City. Those that do claim to comprehend the difference between SIVs and CDOs and who keep an eager eye on the iTraxx and the Case-Shiller Index are probably the dangerous ones – the very people who got us into this mess by being too clever by half. Then again, there have always been financiers who've told the world, and maybe even convinced themselves, that "this time it's different" – the four most dangerous words in the English language.
Well, this time was no different. People who shouldn't have been loaned money duly defaulted; house prices and share prices didn't go up indefinitely, as they never do; bankers made the same mistakes they always did.
It may be that as the late, great JK Galbraith observed, the only thing required for a crash is for sufficient time to elapse since the last one and, thus, for its lessons to be forgotten.
Much of this bluffers' guide sounds new but, in principle, is as old as money and human arrogance; all will return, reinvented and with ever more preposterous labels sometime in the future. The pity is that so many of us – everyone with a pension fund, with savings, with a mortgage, with a job – will suffer for the errors of a very few. But at least if we learn to speak their language, we can understand how we got here.
Former chief executive of Northern Rock. Enjoyed a colourful private life and was the toast of the City. Having turned his bank into "Northern Wreck", he received a £760,000 pay-off, a £346,000 pension top-up and continues to enjoy a cut-price staff mortgage.
American Home Mortgage
Ultimate symbol – and a fair part of the cause – of what has gone wrong. Having sold a few too many dodgy mortgages to willing or unwilling victims wanting to live the American dream (sub-prime loans), what was once one of that nation's largest independent home-loan provider filed for bankruptcy, after laying off the majority of its staff. (See also Sub-Prime; Countrywide; Bear Stearns; Bizarre Victims of the Credit Crunch).
Asset-backed commercial paper (ABCP)
Sounds more impressive than it is, as some have learned to their cost. Commercial paper is simply an IOU written by a company or a bank. The fact that it has some collateral – an asset – attached to it is no use if the asset is worthless, or becomes so, or if lots of other people think it might be worthless.
ABS (Asset-Backed Security)
Almost anything with some kind of collateral; see Commercial Paper.
Bank of England
Lender of last resort to the British banking system, run by Mervyn King (qv). Has been busy lately. Will lend almost any amount to anyone, which sounds a bit like a sub-prime lender.
Second-biggest banking group in the UK and subject of some wild and surely unjustified speculation, though not as wild and surely unjustified as that surrounding HBOS. Barclays Capital helped design SIVs and SIV-lites (see SIV, SIV-lite), and is now helping to rescue some of them, such as Cairn Capital. The man in charge of Barclays Capital (Europe) reportedly went missing for a time (see Sensible, Captain) further worrying the markets and pushing the Barclays share price down. See also Diamond, Bob.
"Before Crunch". A golden age. The bull run. A financial state of grace. It couldn't go on like that.
What happens when the bull run (qv) stops and you get a mauling.
American investment bank that has been the biggest casualty to date, taken over by JP Morgan with American taxpayers' money. One of Bear Stearns's funds was called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, which says it all. UBS, Morgan Stanley, Lehman Brothers, and Goldman Sachs are others who admit vast losses as a result of badly performing assets. See Predictable Victims of the Credit Crunch; Bear Market
The Chairman of the Federal Reserve of the United States, and thus the lender of last resort to America's banks. Bernanke's hobby is the history of the Great Depression. He once referred to a statement by Milton Friedman about using a "helicopter drop" of money into the economy to fight deflation. Hence his occasional nickname of "Helicopter Ben" . His chopper has been seen quite frequently over Wall Street recently. See also Moral Hazard, Greenspan, Alan
Bizarre Victims of the Credit Crunch
The squeeze has reached unexpected places far away from America: Northern Rock, Sachsen Bank, BNP Paribas, IKB. Even Australia.
Closed three of its funds when the crisis broke; that is, it told investors they couldn't get at their money. Has since relented.
Large sums paid to bankers in good times; $310.9bn last year. Could be lower in 2008.
Borrow Short, Lend Long
Classic banking error widely practised recently. If for some reason you can't continue to borrow short and you can't realise your longer-term assets you are, as they say, exposed. See also SIVs.
Nothing to do with him, but it could cost him his job, too.
When shares prices go up.
Warned about the credit bubble long before it was fashionable and urged nationalisation of Northern Rock on the Government months before they drifted into it.
See Sensible, Captain
An SIV (qv) connected to Barclays. Troubled.
The buying of high yielding currencies and selling of low yielding currencies (eg Yen). Leaves one exposed.
The principal US house-price index. Average prices in the main 10 cities in the US fell by 4 per cent last year. Some economists are predicting house prices could drop by between 15 per cent and 30 per cent in the next few years.
Can it keep the rest of the world going with its demand for raw materials and capital goods? Only if we still covet their hazardous toys. See Global Imbalances.
An ABS (qv) structure similar to a CMO (qv), but with a portfolio of bonds as collateral, instead of a portfolio of Mortgage Backed Securities (qv) and/or mortgage loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CBO has more than one "tranche" or "tier", and a more junior tranche has more risk of default.
Collateralised debt obligations: securities backed by a pool of bonds, loans, and other assets. Collateralised debt obligations amount to a $3 trillion market. The "debt obligations" can be anything from collections of mortgages to car loans or credit card/receivables.
A debt security backed by a pool of commercial or personal loans (eg car-finance loans). A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims.
Collateralised mortgage obligations. A type of mortgage-backed security, where different streams of interest and/or repayment of principal are assigned to different classes of CMO holder.
Shorter-term loans issued by banks and bank subsidiaries in vast quantities at low rates of interest. The money raised was used to invest in high-yielding securities backed by sub-prime mortgages – in effect bundles of these shonky loans. In the good old days investors were happy to take these on and renew them when they expired; now no one knows which are toxic. See Borrow Short, Lend Long.
The magical stardust that keeps investment exciting and economies moving.
Another word for SIVs (qv). Conduits are used by banks to fund lending to clients at cheaper rates than they themselves would be able to provide.
Much feared. The notion that the dreaded lurgy will spread from the US mortgage market through the credit markets to equity markets around the world, to such an extent that it triggers a recession. See R-Word; Confidence.
Could It Happen Here?
It already has, to some degree. In the UK, sub-prime mortgages account for about 6 per cent of the market – about half of the proportion prevailing in America. How big is your mortgage?
America's largest mortgage-lender and the recent recipient of a $2bn injection from Bank of America. Things must be bad.
When shares fall by more than 20 per cent.
Where we are. No one's lending, because no one can be sure they'll get paid back and no one knows where those bad American sub-prime loans have wound up. Increasingly that means they won't lend to you either. Bad news.
Unlucky, some say.
Chief executive of Barclays Capital and in the firing line. Managed to make £15m in salary and bonuses last year; could be less next time.
The European Central Bank. Something of a bit-part player until it became clear that many European banks had got themselves into trouble by investing in sub-prime-backed investments. It has had to pour vast amounts of cash into the European banking system.
Episodic Liquidity Assistance
Bankers' version of running a slate at the pub.
As Warren Buffett says: "It's when the tide goes out that you see who's been swimming without their shorts on."
United States Fed. Main job to keep the markets out of trouble.
Financial Services Authority
Not its finest hour.
George W Bush
The 43rd President of the United States and one of the few to wreck both foreign and economic policy. Errors of omission rather than of commission.
America owes China too much money.
The most important figure in the global economy in the past 20 years. Left the Fed after 18 years in January last year. But arguably left an unfortunate legacy – the long run of easy credit and the "Greenspan Put" (qv). Chairman of the Federal Reserve from 1988 to 2006. The man who underwrote the bubble. After the collapse of the dotcom boom in the spring of 2000, the attacks of September 11 2001 and the Enron/accounting scandals of 2002, the Fed lowered interest rates until they reached a nadir of 1 per cent in June 2003, where they stayed for a year before gently rising. Such historically low levels (negative in real terms) had the desired effect of bolstering financial markets, but also fed through to consumer price-inflation and, more dangerously, a real estate and financial bubble. It also created the Greenspan Put (qv). Greenspan was also phlegmatic about the sub-prime phenomenon: "Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately." Aged 81 and still having fun.
A one-way bet. The assumption that intervention by the Fed and other central banks will always bail out the markets with an interest-rate cut when they get themselves into difficulties.
They used to sell shares they didn't own; nowadays just an umbrella term for huge private investment funds that buy shares, bonds, securities and companies that they probably shouldn't. Usually looking for opportunities at the unconventional end of the market.
The High-Grade Structured Credit Strategies Enhanced Leverage Fund
Proof that you really shouldn't invest in things you can't understand. A Bear Stearns banker's idea of fun.
German bank that had to be rescued after getting into trouble.
Injection of Liquidity
Things are bad when investment houses have to go looking for cash from the Bank of England or the Federal Reserve.
Indicator of how risky bonds issued by banks and large private companies are in relation to safe government-backed debt.