The causes, course and impacts of the current turmoil in global financial markets

As a result of the crisis in the US sub-prime mortgage market, the global financial markets have been experiencing a period of increased volatility since the July Inflation Report was published. In August, this culminated in a liquidity shortage on the global money market and a threat to the stability of financial institutions with heavy exposures in the sub-prime mortgage market.

The roots of this crisis can be traced back to 2001, when the Fed slashed interest rates in an effort to mitigate the impacts of the bursting of the stock market bubble. The key federal funds rate was lowered from 6.50% to 1.75% during 2001, reached 1% in mid-2003 and remained at this level until mid-2004 (see Chart 1). In real terms, short-term rates in the United States remained negative until mid-2005. Such low interest rates for such a long time fuelled a bubble in the US property market.

The surge in property prices had two main effects. First, the total volume of mortgages soared and households increasingly used money borrowed against the rising value of their homes to fund current consumption. Second, the credit standards of the banks providing mortgages slipped as the value of collateral rose. This trend was bolstered by the fact that the mortgages were not left in the banks’ balance sheets but were immediately sold on to investors as “mortgage-backed securities” (MBSs). Whereas in 2001–2003 sub-prime mortgages had accounted for just 10% of total mortgages, in 2006 their share was 33%.

At the start of this year it started to become apparent that the credit cycle was entering a new phase. The Fed’s key interest rate of over 5% started to gradually push down property prices. At the same time, the proportion of unpaid mortgages increased, reaching its highest level in almost 20 years. The prices of MBSs and the securities derived from them started to fall. The owners of these securities started to have liquidity problems, resulting in increased demand on the interbank money market. This generated a surge in interest rates – and subsequently also interest rate volatility – on the global money market, particularly at the shortest maturities (see Chart 2).

The strongest responses to this situation came from the European and US central banks, which supplied the interbank market with extraordinary liquidity. Despite a subsequent partial calming of the money markets, there remains much uncertainty among market participants about future developments and about the potential effects of the financial market turbulence on the real economy. So far, some deterioration has occurred in the growth prospects for the US economy (and partly also the European economy), to which the Fed has responded by cutting rates. There has also been a shift in the ECB’s rhetoric, as a result of which the financial markets have shifted their view towards rate stability in the euro area.