- Jul 15, 2008
Pressure now mounted on the banks. Not only were they struggling to raise funds in money markets and to straighten out their troubled SIVs, but their mortgage holdings also suddenly turned toxic. They couldn’t even count their losses because trading had collapsed in the mortgage securities market; thus, pricing their mortgage assets was all but impossible. Banks began feverishly writing down the value of these assets, although it was unclear how large those write-downs should be.
The banks were further hurt as investor angst over mortgage credit quality spilled over into corporate credit, particularly for lower-rated loans and bonds. These “junk” loans and bonds had financed a wave of leveraged corporate buyouts and had been very lucrative for the banks, but they were supposed to be temporary; banks expected to quickly resell them to investors. Now investors stopped buying, so the loans were stuck on the banks’ balance sheets. That puts the banks at significant risk if the businesses involved in these leveraged buyouts begin to falter, a growing likelihood in a weakening economy. At the very least, these loans tie up scarce capital—the dollars regulators require banks to set aside in case of credit problems. This impairs the bank’s capability to extend credit to other borrowers. A bank’s capability to lend depends on how much capital it has; less capital means less lending.
Other parts of the credit market were now feeling the stress, as investors grew wary of all risk. Prices for lower-quality bonds backed by auto and credit card loans fell sharply, as did prices for the commercial mortgage securities used to finance the purchase and construction of office towers, shopping malls, and hotels. Bond issuance declined substantially, with junk corporate bond issuance stalling and even well-performing emerging economies pulling back on the debt they were willing and able to sell.