Who got us into this mess, what did they think they were doing, and how do we get out of it?
By Emma SimonLast Updated: 4:04PM BST 13 Oct 2008
A trader in Frankfurt reacts to the latest turmoil in the markets Photo: REUTERS
Q: How have the banks got into this situation?
A: The problems started with the now notorious sub-prime mortgages in America. Banks granted home loans to people who had little chance of repaying them, but then sold these debts on to other banks, often packaged up with other less risky debts. Invariably these debts, and other high-risk securities, were sold on again. But then it became apparent that some of these loans would not be repaid, and banks were left holding "toxic'' debts.
More worryingly, banks were now unsure which institutions were most exposed to these bad investments, and drew back from lending to each other, amid concerns that the money would not be repaid if a bank failed.
The collapse of Lehman Brothers, the US investment bank, last month intensified this fear and effectively paralysed global money markets. Since then, central banks and governments have been hatching plans to restore liquidity and confidence in the banking system, so oiling the wheels of capitalism again.
Q: Why do banks need to lend to and borrow from each other?
A: Most people assume that banks work on that old-fashioned notion of only lending out the money taken in on deposit. But this rarely happens today. The money taken in as savings is invested in the money markets - in other words, lent to other banks for the best possible rate. Banks then borrow from these same markets and sell on this money, at a premium, to customers in the form of mortgages and personal loans.
If banks are unable to borrow from each other, and from these money markets, then they are unlikely to be able to offer competitive borrowing deals for consumers, and we may have to go back to the days when mortgages were "rationed'' and depended solely on deposits.
This also explains why banks would be unable to repay savers if these decided en masse to empty their accounts. Such a run on a bank can drive a profitable institution to the brink, potentially taking savers' money with it.
Q: So is my money safe in the bank?
A: Before Northern Rock collapsed a year ago, few people would have worried about the safety of their money in a British bank or building society. But with Northern Rock, Bradford & Bingley, HBOS and now Icesave running into difficulties, the security of our savings has become more important than the interest rates they earn.
Despite these problems, savers have yet to lose a penny. The closest savers have come to losing out has been with Icesave, a subsidiary of the Icelandic Landsbanki Bank. British savers saw their money frozen, and there were fears that the Icelandic compensation scheme would not pay out. But Alistair Darling, the Chancellor, confirmed that the Government will reimburse savers in full through the Financial Services Compensation Scheme (FSCS).
Q: Are all savings guaranteed?
A: No. The Government has been careful not to offer a blank cheque underwriting the nation's savings in full. It was only able to make this pledge to Icesave's UK savers because of the "exceptional'' economic circumstances.
Given the market volatility, savers should ensure that they have no more than £ 50,000 with any one bank, as this is the maximum that is guaranteed to be protected under the FSCS. This limit often applies to all brands offered by one banking group.
Take care with foreign-owned institutions, as very often you will have to reclaim the first euro20,877 (£ 16,500) from an overseas compensation scheme. If you are nervous, then stick with the UK, where at least as a vote-wielding citizen your money should be the top priority for the authorities.
Q: Why are share prices still falling? Has the Government bail-out failed?
A: Last week the Government unveiled a £ 500 billion rescue package for British banks. This trumped the US rescue plan in both size and scope, pumping liquidity and capital into our struggling banking system.
Although the plan is complex, at its core are three main policies:
- to offer extended borrowing facilities so that banks can access funds from the Bank of England;
- to recapitalise banks by injecting money directly into them in exchange for a stake in the bank; and
- to guarantee all new debt issued by banks, effectively making their corporate bonds as safe as Government-backed gilts.
But these radical measures failed to stem the stock-market rout, and bank share prices continued to head south.
This does not necessarily mean the bail-out has failed. The Government will argue that this is a long-term plan to put the banks on a firmer financial footing. Yesterday's pledge by G7 finance ministers to pump public money into banks to prevent their collapse could also translate into a recovery in share prices.
Q: So what is spooking investors? Is there much worse news to come?
A: It isn't just a lack of confidence in the banks that is driving share prices downwards. Fears of a recession are causing shares to be sold off in many companies. In a recession, consumer spending, already down, will dip further. This will affect companies' profits.
There are also fears that recession and unemployment could lead to more toxic debt. It is not just sub-prime mortgages: credit card debt and car finance deals may also have to be written off if consumers can no longer meet repayments.
Q: The credit crunch has been around for a year - why did it get so much worse this week?
A: Panic is breeding panic. The fact that the much-lauded rescue plans, coupled with a global interest-rate cut, have done little to staunch the rout may have raised the fear factor, as it is clear that Government and banks have little else to throw at the problem.
Q: The Government pumped money into the system before. Why didn't this work, and why do they think more money now will do the trick?
A: The Government already had a £ 100 billion Special Liquidity Scheme in place which allowed banks to borrow from the Bank of England. This has been doubled in the hope that, by giving banks access to more money, they will start lending to consumers again.
Q: This is an extraordinary amount of money. Are we going to have to pay more tax as a result?
A: This plan puts taxpayers' money at risk, but will not necessarily mean they lose out. If the plan revives banking fortunes then the Government could make money for taxpayers by having bought into the banks at such a low ebb. The money lent to them through the liquidity scheme will also have to be paid back. But if it doesn't work, we could be paying for generations, through higher taxes or cuts in public spending.
Q: Why should we pay more tax to save the banks? They got themselves into this mess.
A: It is not hard to see why this rescue package has been so controversial. Many people wince at public money being used to bail out an industry that has shown little restraint in pay and bonuses. But without this help, more banks would fail, causing misery for all. Bank collapses could put savers' money at risk; reimbursing that could cost the taxpayer far more.
Q: How far can share prices fall?
A: This is the billion-dollar question. Following the bubble in technology stocks in the late 1990s, the FTSE 100 share price index peaked at 6,950 in December 1999, before falling to a low of 3,287 in March 2003. We are still marginally above this point. However, the factors driving this crash are different and prices could head still lower.
Q: Is it too late to get out now?
A: If you have left it this late to get out of the market, it is probably too late and you are just crystallising large losses. Experts' advice is to wait for recovery, which will - eventually - come.
Q: Will shares just bounce back?
A: We have no way of knowing what the recovery will be like. In the 2003 crash, share prices recovered swiftly. But many experts are drawing parallels with the 1930s or 1970s, when recession stalled a recovery for years. There is also the salutary lesson of Japan. In December 1989, the Nikkei index peaked at 39,000 before suffering a catastrophic loss, sparked by a banking crisis. Today, almost 20 years later, it stands at just about 8,000.
Q: I don't own shares. Why should I care about the stock market?
A: You probably have investments that are exposed to equities, be it a pension, unit-linked savings, an endowment, trust fund or savings bond. Their value will have fallen by roughly a third over the past year, depending on what shares your plan is invested in. A stock-market collapse will also deepen a recession, resulting in job cuts.
Q: Why is my mortgage rate still high when base rates have been cut?
A: Many British banks have passed on this interest-rate cut, but there have been exceptions, including Abbey, Nationwide and HSBC. Most banks are not re-pricing new mortgage deals, because these are largely based on Libor - the inter-bank lending rate - and this has remained stubbornly high.
http://www.telegraph.co.uk/finance/personalfinance/3187716/Financial-crisis-Everything-you-need-to-know-about-the-meltdown-but-were-afraid-to-ask..html
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