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Is there any end in sight? (1)
Stock markets worldwide have been experiencing enormous volatility, with major intra-day swings and heavy consecutive daily losses? only to be followed by a recent series of gains. The major concern affecting international financial markets at the moment is an uncertainty about how the current problems triggered by the subprime mortgage crisis in the US will eventually pan out.
Although the crisis led to a liquidity squeeze, several central banks were quick to react by injecting liquidity into the money markets. In addition, the US Federal Reserve Bank (Fed) announced a 50bps reduction in its discount rate. These measures have been welcomed positively by investors, but there is still uncertainty about the medium and long term impact of this crisis on global economic growth and hence on fixed income and equity markets around the world.
?why is it happening?</B>
To understand what is currently happening in international financial markets (major ones in particular), one has to go back to mid-2005, when the housing bubble in the US began to fizzle, after almost four years of boom. Moreover, increasing delinquencies (late payment of mortgage installments) in the subprime segment of the mortgage market began to become apparent. Back then, most analysts remained divided on whether the US economy would consequently have a soft landing or a hard one. Things got more serious however when losses related to the subprime mortgage market started surfacing by mid-2006, thereby triggering talk of a recession. (Subprime mortgage lending also called ?second chance lending? refers to the practice of making loans to borrowers who do not qualify for the best market interest rates due to their poor credit history. Lending by mortgage providers to the subprime and Alt-A (almost subprime) categories of borrowers accelerated in 2005 and despite a further increasing delinquency rate even continued through 2006!)
ARM delinquencies and foreclosures</B>
The effect is not confined to the USA?
To finance these subprime mortgage loans, banks packaged them up with all sorts of other loans (some with good and some with bad ratings) to create structured financial products broadly known as ?asset backed securities?, which in theory at least enables the spreading of risks among several categories of investors. These were then sold to hedge funds, investment banks and central banks around the world. As the value of homes (the ?asset? backing those securities?) in the US continued to drop, there was a sharp increase in foreclosures as the value of those homes was lower than the value of the loans taken. This caused the structured products not to behave as they were expected to!
Moreover, as the liquidity squeeze took hold, prospective buyers for those securities disappeared. The value of such securities then became a very thorny issue indeed since computer models became irrelevant and large custodian banks/pricing agents were no longer able to price them. As a result, several high-profile institutional hedge funds (particularly those which had been heavily leveraged) reported immense losses and the share prices of the investment banks running these hedge funds fell heavily. This malaise then spread to other banks believed to have exposure to those structured products and throughout global equity markets generally (the MSCI index charts shows the market pronounced equity market declines as from mid-late July).
We use the phrase ?banks believed to have exposure? because nobody really knows (except the banks and funds that have mentioned it) who has structured products and how many bad loans these products contain. Recently, even banks became very reluctant to lend to each other, which led to a spike in the overnight inter-bank lending rate. In an attempt to prevent liquidity from drying up, the European Central Bank (ECB), the Fed and other Asian central banks had to pump liquidity into those markets. Of course the potential for recession in the US has had a negative impact on Asian markets, not only because of the structured products that some of their banks and funds have bought but also because of their exports which would be affected by any US economic downturn.
Furthermore if corporations find it more expensive (or difficult) to raise capital through the debt markets, it could certainly have an impact on capital expenditure which could lead to a global economic slowdown. Global stock markets (but particularly those in the US and Europe), which have benefited enormously from the huge spate of private equity/merger and acquisition activity were also discounting a decrease in the extent of such activity from the higher cost of leveraged loans used to finance such deals.
?but where did the fuel for the boom come from in the first instance?
The global ?carry trade? can be partly blamed for fuelling the boom in the stock and property markets over the recent years. The carry trade occurs when investors borrow in a low interest rate currency and then invest in a high yielding one. In essence, given the low level of interest rates that Japan and Switzerland have had and still have relative to the US in particular, investors have been able to borrow in the Japanese Yen and the Swiss Franc and then invest in higher yielding assets, for example emerging market and high yield debt, higher yielding debt/currencies (e.g. of New Zealand, Australia etc.) equities and the structured products which contain the subprime loans. As such, concerns have been expressed that this turmoil, which has hit the stock and capital markets the hardest so far could well endanger the global currency market should investors further unwind their risky positions in the Yen and Swiss Franc carry trades at a faster rate than holding safer assets.
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