Since the beginning of the US “subprime” crisis and the financial turmoil that has affected the world’s economies, there has been talk of “toxic” borrowing , which has affected not only banks – often origin of the problem – but also states, local authorities and even administrations .
What is a loan without risk?
To understand how credit can hurt an economy, it’s helpful to remember what a risk-free loan is. A debt can be considered harmless – whether it is for an individual or a corporation – when the borrower pays only the interest provided for in the loan agreement.
It does not matter whether the rate is fixed or variable or a combination of the two mechanisms. In the case of a revolving rate loan, the borrower pays interest based on a benchmark plus a margin corresponding to the lender’s earnings.
This financial index may be the EONIA (average daily rate practiced between banks) or EURIBOR (rate between banks from 1 month to 1 year).
The mechanism of “toxic” borrowing
The complexity of the formulas for calculating these so-called “toxic” loans has nothing to do with those used in those of a variable rate loan, namely:
Toxic borrowing uses other risky financial variables such as the exchange rate or inflation. The advantage that has been put forward to local authorities or administrations, who have followed the advice of their lender DEXIA , was to benefit from a fixed rate lower in the first years, which would thus alleviate the burden for a while.
However, once past this period of improvement, the interest rate should then result from complex formulas, based on a certain number of alternative conditions that, following or not their realization, could make the rate higher or lower.
One of these calculation formulas, called “swap” proposed for example to change the rate after a first period of fixed rate. In this second part, the lender sometimes used leverage.
This is a multiplier that applies to the financial index for calculating the rate. A leverage X2 means that the risk is doubled by two.
In this dangerous game, we do not know exactly which local authorities and administrations have subscribed these toxic loans but it seems that the financial crisis has not yet shown its full extent.