What turned a cyclical downturn into a crisis was the fact that the innovators of Wall Street, seeking ways to lend and earn as much as possible and to take advantage of investors' demand for assets, had packaged mortgages into complex financial instruments which were assigned high credit ratings. After US property prices sagged in 2006 and borrowers began to have trouble with repayments, holders of mortgage-backed securities – into which loans of differing quality had been packaged – struck a severe problem: nobody knew how to value their holdings.
Special investment vehicles set up to maximise profits from holding these packaged securities could no longer fund themselves and began to collapse. Banks were suddenly exposed to huge losses, since all holders of mortgage-backed securities had to mark down the value of their portfolios drastically. By August 2008, according to statistics compiled by Bloomberg, banks around the world had written off amounts totalling $501bn (see table). Many banks raised new equity capital to help cope with the losses.
The two remaining large investment banks, Morgan Stanley and Goldman Sachs, whose share prices were falling as the markets saw them as the next candidates for failure, then turned themselves into commercial banks and received equity injections from new investors; in Goldman's case one was the investment guru Warren Buffett. On 25 September came the failure of the sixth-largest US bank, Washington Mutual, which was seized by regulators and sold. This was swiftly followed by the rescue of the fourth-largest bank, Wachovia.
Banks' difficulties in obtaining money-market funding led to failures and rescues across Europe. In the United Kingdom, the main casualties were mortgage-lending banks. Northern Rock had suffered a run in 2007 and was nationalised, and Alliance & Leicester was acquired by another bank. In September, Bradford & Bingley was nationalised, and HBOS was rescued by a takeover bid from Lloyds TSB.
In Belgium, the financial conglomerate Fortis was saved by a combination of acquisition by BNP Paribas of France and nationalisation by the Dutch government. In Germany, Hypo Real Estate was rescued by a €50bn credit package from the government and private banks.
Iceland's banking system collapsed, and, amid concerns the country itself might become bankrupt, the government turned to Russia for a loan. Russian markets suffered major disruptions.
As all this was occurring, international money markets remained paralysed. Central banks made hundreds of billions of dollars available to provide liquidity to the money markets.
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