The latest crisis in financial markets has once again served as a reminder of how vital and interconnected the health of the U.S. economy is to that of the rest of the world.
From New York to Frankfurt to Tokyo, markets were jolted in the past week by fears that Americans are failing to keep up with their mortgage payments and the ripple effects that could have on the global banking and financial system.
The fallout could further depress U.S. housing prices by making it harder to find buyers for a glut of foreclosed homes. That, coupled with a drop in the value of investments, could leave U.S. consumers feeling poorer and less likely to spend on domestic and imported goods.
“The sharp falls in global stock markets obviously affect consumer wealth, which again could dampen spending,” said Howard Archer, chief British and European economist at Global Insight.
The most immediate effect for the half of all American households who own mutual funds and other individual investors worldwide is a decline in the value of their investments, which may or may not be short-lived.
Around the globe, small-time investors are taking a beating. Stock prices have slid in recent days as fears of the market crisis infected markets worldwide. Worried investors sold stocks but finding buyers was hard, which caused share prices to dip even lower.
“We all feel threatened, problems on the stock exchange have consequences for the economy of America and of the world” said Gabriella Savarini, a 69-year-old shopkeeper in Rome. “America influences all, for good or for bad.”
The distress in the markets makes it harder and more expensive for businesses and consumers to get loans and cash, Archer said. If companies cannot get loans, they cannot expand and may have to cut expenses, typically through layoffs.
America faced a crisis similar to the current mortgage fiasco when hundreds of savings and loan companies went belly-up in the 1980s. Back then, the fallout did not spread dramatically to foreign shores because the U.S. government stepped in to bail out the banks and repay depositors.
But the past two decades have seen a quantum leap in globalization and outsourcing, crumbling trade barriers, and a revolution in financial markets have knit the world tightly together.
A steep sell-off in global markets on Thursday and Friday was triggered by distress signals from France’s biggest bank, BNP Paribas, which had to freeze billions of dollars in assets in three mutual funds because of the falling value of securities linked to high-risk mortgages taken out by U.S. borrowers.
“I’m sitting here in Brazil and Brazilian markets have gotten crushed by this. ... It’s hit all the emerging markets,” said Kenneth Rogoff, a former director of research at the International Monetary Fund and now a professor at Harvard University. “If this were to snowball next week, it would affect markets in Turkey, Indonesia.”
Global interdependency isn’t a recent phenomenon: The Wall Street stock market crash of 1929 and the Great Depression affected the entire world, and helped create the conditions for the rise of fascism in Europe.
But with faster communications and real-time trading, market jitters in New York race around the world almost instantly today.
At the center of the concerns are high-risk loans to individuals or businesses made by banks globally.
More Americans are failing to keep up with their home mortgage payments, and there are concerns that this could ripple around the globe because much of the debt from mortgages has been packaged into securities sold to pension funds, banks and other investors who were hungry for high returns on investments.
The same mortgage securities in the U.S. that are crumbling in value are a part of bigger holdings that banks from Japan to Germany bought into because of low U.S. interest rates and a good returns. That is, until the mortgage holders started defaulting.
Meanwhile, the ability of banks to convert assets to cash quickly was in doubt because some were unable to track how much money they poured into now worthless securities backed by sub-prime U.S. mortgages, or loans made to high credit-risk individuals.
Those bad loans raised fears of broader credit troubles that could affect the entire banking and financial system — concerns that caused stock markets to plummet and threatened pensions.
The slide started innocuously in April after New Century Financial, a U.S. mortgage lender whose principle borrowers were Americans with less-than-stellar credit, filed for bankruptcy protection. Its customers were people who may have been late on credit card payments, maybe even filed bankruptcy in previous years, but still wanted a shot at buying their own home.
Lenders were only too happy to oblige — flush with cash and eager to exploit new markets so they could, in turn, lend more money and increase their profits.
Hedge funds and banks worldwide saw a market with opportunity and bought up mortgage-backed securities.
A month later, USB AG, the giant financial company, said its hedge fund business had lost $125 million in the first quarter largely on the back of investments in the U.S. sub-prime mortgage field. Then in July, Wall Street’s Bear Stearns closed a pair of hedge funds after it lost more than $20 billion on mortgage-backed investments.
In early August, concerns mounted that those mortgage securities may not have been as solid as people thought.
Those fears were capped by the Aug. 6 bankruptcy by Melville, N.Y.-based American Home Mortgage Investment Corp. American Home, once a major U.S. mortgage lender, said it fell victim to “extraordinary disruptions” that effectively cut off the funding it needed to make new loans.
On Thursday, France’s biggest bank, BNP Paribas, froze $2.2 billion held in three funds because their exposure to sub-prime mortgages in the U.S. That intensified fears that risk was spreading worldwide.
With cash reserves running low, the interest rates that banks charge each other for overnight loans rose so steeply that central banks in the U.S., Europe and Asia poured tens of billions of dollars into the market to make sure enough cash was available to meet demand.
Such large-scale central bank interventions are rare — that last major injection came immediately after the Sept. 11 attacks in 2001.