Home > Articles > Business & Management > Global Business

  • Print
  • + Share This
This chapter is from the book

Money Stops Flowing

The mortgage securities market wasn’t the only casualty of the subprime shock. Very quickly, global money markets began to suffer as well, thanks to a complex chain of financial links that few outside these markets had noticed or understood previously. Over the course of several years, major U.S. and European money center banks had established so-called structured investment vehicles, or SIVs. These are entities set up to invest in a wide range of assets, including subprime mortgage securities, with money they raise by selling short-term commercial paper. Commercial paper (which businesses have historically used to purchase inventory that will soon be sold or for other short-term financing needs) is a mainstay of the money markets because it is regarded as both safe and liquid. Millions of savers who use money markets as an alternative to passbook bank accounts or certificates of deposit are investing in commercial paper, whether they know it or not.

In a time of low interest rates and easy credit, SIVs could easily and cheaply issue short-term commercial paper and use the proceeds to buy longer-term mortgage-backed securities. Now, however, money market funds and other investors began to lose faith in the commercial paper SIVs issued. The SIVs were effectively out of business.

It is a truism to say that financial markets work on trust. Each party to a deal must trust that the other side will honor its commitments. Lenders must trust that their loans will be paid back; investors must trust that they will see a return on their investment. But no market depends more on trust than a money market, in which the transactions are large and are held for short periods of time. Without trust, money markets quickly break down. By late summer 2007, trust in the SIVs had evaporated. Investors shunned their commercial paper, forcing the SIVs to sell their assets at increasingly distressed prices, thus accelerating the downdraft in financial markets generally.

Short-term lending within the global banking system was also disrupted, as a string of banks began to report losses on their mortgage-related holdings. The distress appeared particularly acute in Europe, as several prominent German and British institutions stumbled. But these high-profile affairs were assumed to be just the tip of the iceberg. With U.S. mortgage security holdings so widely dispersed, and with little information about who was suffering losses and to what extent, banks shrank from doing business with each other. Fewer thought it prudent to borrow or lend, and those that would demanded substantially higher interest rates to compensate for the greater risk they now believed existed.

  • + Share This
  • 🔖 Save To Your Account