Subprime Mortgage Crisis Headed Overseas

The overzealous lending practices that led to rising default rates are influencing more than just the U.S. economy-they're extending across the ocean, as well.

In the 1995 suspense film Outbreak, a highly contagious virus spins widely out of control. As the crisis worsens, the government considers extreme measures to prevent further spreading. In real life, bad situations aren't so easily contained-as demonstrated by the ongoing and widespread effects of the U.S. subprime mortgage crisis.

As mortgage trouble continues in America, it has sparked a series of events that's led to bank failures on the other side of the world. Some European banks-entities that never made any mortgage loans to U.S. subprime borrowers-are having to accept emergency government funds just to stay in business. While these banks aren't directly involved in the subprime crisis, they're feeling the downturn nonetheless.

The circles of influence run wide in the global financial markets. There are two general reasons why. First, information moves quickly. A negative incident in the U.S. becomes known halfway around the world in just moments. Secondly, the financial markets of today are interconnected, due to the practice of securitization.

Spreading the risk around

Securitization is the repackaging of assets for the purpose of selling them in standard issues to investors. This is done to convert a non-traded asset, like a pool of mortgage loans, into a form that can be bought and sold by investors. In the good old days, investors were attracted to these aggressive mortgage-backed securities because the underlying subprime loans, in theory, provided high-rate, long-term cash flows.

At the height of the mortgage boom, investors around the world were demanding more and more mortgage-backed securities. Some of these investors were bank-created, off-balance sheet entities, known as conduits or securitization vehicles. Many of these entities were in the business of issuing short-term commercial paper and using the proceeds to buy up mortgage-backed securities.

When subprime defaults began to rise to startling levels, rating agencies downgraded many mortgage-backed securities, thus reducing their value. Conduits and securitization vehicles holding these securities were suddenly unable to refinance their short-term commercial paper as it came due. They turned to the banks that had created them to obtain financing. Some of these banks provided the financing, only to be unable to recover from the huge draw on their funds.

All fall down

Spotting this trend, other banks throughout Europe began hoarding their funds, fearing that another conduit would need financial support. As a result, LIBOR-the interest rate that London banks charge one another when lending funds-began to skyrocket. Although the Bank of England has moved in to provide more funds to London banks, LIBOR has continued to rise. Other regional financial markets are experiencing similar circumstances.

In today's interconnected world, financial crisis really does spread like a contagious disease. At this point, it's tough to predict the endpoint. All consumers can do is brace themselves for more stormy financial conditions ahead.