The US Subprime mortgage crisis was a banking and financial emergency situation that led to a recession not only in the US but spread to many parts of the world. The disastrous effects of a crisis in the domestic subprime market on the rest of the world beg questions about the interconnectability and interdependence of the international economy as well as the financial institutions. The international financial crisis also revealed how vulnerable the global financial system was. Not only did the subprime crisis have a direct effect on global markets and countries that held a huge number of US mortgage backed securities and were dependent on dollar funding, it also served as a trigger that indirectly affected the rest of the global market. The Subprime crisis in the US also exposed the high risk business models of banks and financial institutions around the world such as short term funding in excess, lack of transparency in balance sheets and risk aversion swing. Foreign markets suffered a meltdown either due to direct linkages with the US markets or indirect linkages. It thus becomes important to find out the transmission route of the crisis from the US to other parts of the world. The question is whether the international financial crisis was a result of direct or indirect contagion and how much each factor played a role. Answers to this question would help in developing frameworks and financial models that would help reduce the vulnerability of global financial institutions and markets.
Global financial crises such as the Asian and Russian financial crisis of 1997-98 and the Tequila Crisis of 1994-95 with the onset of neoliberalism and increasing globalization led to a emergence of literature on ‘financial contagion’. The literature focuses on two broad categories of contagion- direct and indirect (Claessens, Dornbusch, and Park, 2001; Karolyi, 2003). A direct contagion is when economies of other countries suffer as a result of the bankruptcy of one country either due to trade relations or investments or common shocks such as the sudden increase or decrease in oil and raw material prices. A direct contagion brings out the real and tangible financial linkages between countries and the financial institutions. Indirect contagion on the other hand happens when there is no direct and real financial linkage but the damage is still done due to herd mentality or a panicky behavior in the stock markets that has a domino effect. The wake up call hypothesis suggests that investors fleeing from a market could possibly head to similar markets causing further losses (Goldstein 1998). Irrational panic results in panic moving of funds even where there is no serious cause for concern. In the case of the US subprime crisis, there were both direct and indirect contagion effects-spreading the crisis worldwide.
The subprime crisis in the US largely began because of the ‘ninja loans’ which stood for no income, no job and no assets (Dodd & Mills 2008). These loans were risky as repayments were based on the belief that the housing prices would go on increasing (the housing prices in the US had not gone down since the 1930’s). Increasing prices would help the customers refinance their loans and in case of default, the banks could always recoup their losses by selling of these houses. The loans were also marketed using initial teaser rates where the customer did not have to pay the interest for a few months or had to pay only a nominal rate. It was only when the teaser period ended and the customer had to pay the real rates that the problem started. Since these were high risk loans to begin with, a lot of defaults happened and the market was plunged into a crisis. People could not afford to pay their interests and banks could not sell the repossessed houses. To make matters worse, these loans were also repackaged and sold again. In short, houses and loans were sold to people with very little money or no money at all.
One of the reasons for the spread of the US subprime crisis globally was the fact that many countries had heavily invested US stocks. These investments were not only in stable stocks such as the US treasury but was spread over all kinds of assets. Mostly there was heavy foreign investment in the corporate bond debt and since most of the debt included asset backed securities, the subprime crisis hit not only the local financial institutions but also anyone who had invested in it. When the housing prices fell and interest rates shot up, customers could no longer afford refinance their loans and could not pay the monthly installments which had shot up. When they defaulted, the financial institutions suffered huge losses which hurt the investors as well. Another reason for the spread of the crisis was the repackaging of the Asset Backed Securities. When the institutions bought the ABS from US banks and other financial institutions, they repackaged them for further sale to US citizens. These alone ran to billions of dollars. Such direct exposure to bad loans and repackaged ABS meant that as the crisis worsened in the US, the investors too would be badly affected. The need for dollar funding by foreign banks was also a reason for the spread of the crisis beyond the US borders. In order to finance their ABS, foreign banks increased their cross border dollar liabilities and when there was a credit crunch, these banks found it extremely difficult to manage their liabilities and had a very small scope to improve funding. While banks with US subsidiaries could manage the dollar inflow, foreign banks that were more regional could not do so and had to shell out higher interest rates to get more funding thereby placing pressure on their assets.
The crisis also spread to foreign markets and banks that did not hold the subprime stocks-original or repackaged. Lack of transparency in the repackaging structure of the bonds spread doubts about the actual losses of the players and the extent of the damage. This spread wide spread concern around the world as investors were frantically taking out their money and moving it into safer havens. This led to a high demand for liquidity and banks that ran of short term funding could not meet with the demands. Although Banque Paribas was the first and one of the very few to openly admit it, many banks faced a liquidity crisis as investors wanted to move their money. This set up a contagious bank run scenario around the world. The onset of the crisis also sparked heavy selling which resulted in the prices of the stocks going down. More than everything the crisis revealed the similar high risk practices of banks and financial institutions around the world. The spread of the financial crisis was thus partly due to the direct involvement of foreign players in the US subprime sector and also due to the interconnectedness and similarity of financial institutions and banks around the world. Direct and indirect contagion played equal parts in spreading the US subprime mortgage crisis around the world.
Claessens, Stijn, Rudiger Dornbusch, and Yung Chul Park. (2001). “Contagion: Why Crises Spread and How This Can Be Stopped.” in Stijn Claessens and Kristin J. Forbes, eds., International Financial Contagion. Kluwer Academic Publishers: Boston.
Karolyi, Gorge Andrew. (2003). Does International Financial Contagion Really Exist? International Finance. 6(2), 179-199.
Goldstein, Morris (1998). The Asian Financial Crisis. Peterson Institute for International Economics. Policy Brief 98-1, March.
Dodd, Randall and Mills, Paul (2008). Outbreak: U.S. Subprime Contagion. Finance & Development. 45 (2). http://www.imf.org/external/pubs/ft/fandd/2008/06/dodd.htm.