From The Sunday Times (of London) - October 12, 2008
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Last Monday, before the latest turmoil erupted, members of the House of Commons Treasury select committee were in Japan seeking to learn from that country’s experience of financial crisis 20 years ago.
Through the 1980s share and property prices in Japan had roared and soared, with the Nikkei stock market index peaking at just under 39,000. After the bubble burst in 1989, the Nikkei slumped by 80%, finally bottoming out at just over 7,600. Property prices also crashed. For years the economy stagnated and the stock market never fully recovered.
Japanese officials were keen to explain to the British MPs why the sclerosis has persisted so long. One big problem, they said, was the banks. They were slow to own up to the full scale of their losses, so the financial authorities wasted years fighting fires in individual banks instead of reforming them at one stroke. That meant that Japan’s banking system remained too weak to do its job of sustaining economic activity by borrowing and lending. Only government action eventually forced the issue.
“The Japanese told us that we will have to nationalise not just a few banks — that would be just the first step,” said Michael Fallon, the deputy chairman of the Treasury committee. “They told us that we would have to nationalise the entire banking system.”
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“Many of these banks have lied to us,” Fallon said, referring to Treasury committee hearings. “They have told us they have solid loan books when they didn’t. They told us they weren’t exposed to the US sub-prime market or the buy-to-let nonsense, when they were. That happened with Northern Rock, Bradford & Bingley and HBOS.”
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As losses and panic spread through the financial system, some experts predict that the next big problem will be the market in credit default swaps.
These obscure financial instruments began to be widely used in the 1990s as a way for companies to insure themselves against borrowers who failed to pay their debts. In simple terms, a company worried that it might not get paid by a borrower strikes a deal with another party to compensate it if the borrower defaults. The risk is transferred and thus it is called a “credit default swap” (CDS).
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As companies run into difficulty in the recession, loan defaults will rise. That, in turn, will put pressure on the CDS market. If firms that have offered default protection find they cannot now pay, it could have a domino effect — one firm’s default could cause a different one to go bankrupt.
That, and the proliferation of the market, is why Buffett warned that the CDS and other derivatives are “financial weapons of mass destruction”.
http://business.timesonline.co.uk/tol/business/economics/article4926735.ece