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How a credit crunch may hurt the world economy

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In part, what's happening is a reappraisal of the risk inherent in making loans. During an era of low interest rates and solid global growth, it was the potential rewards that captivated bankers, borrowers, and investors.

Now, banks face rising loan defaults and a possible recession in the US economy – an event that would have strong global ripple effects. So they are turning more cautious and reining in access to credit. It's not just mortgage loans that are going bad. Default rates are also rising for auto and credit card loans. Also at risk are loans to corporations making leveraged buyouts, and loans for commercial real estate.

Housing markets have weakened in Britain, Ireland, and Spain. But so far, the biggest problems are with investments tied to home loans in America.

"We know that around $700 billion in US mortgage debt has been [packaged into investments and] distributed abroad," says Desmond Lachman, a former International Monetary Fund official, in an e-mail interview. Add other loan troubles, and "this adds up to large likely losses to the global banking system."

What's 'SIV' got to do with it?

Don't know what a SIV is? The financial industry has grown ever more creative in recent years, and now one of the biggest challenges is sorting out the unknown risks of complicated products. Consider:

• Banks set up structured investment vehicles (SIVs), which derive income by making loans with borrowed money. Now, after other firms stopped lending to these SIVs, banks in effect are being forced to lend to themselves. They are bringing the SIV loans back onto their books – and marking down their value to reflect new realities. Europe's biggest bank, London-based HSBC, recently said it will absorb about $45 billion in SIV assets.

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