Sunday, August 26, 2007

Overview of August's Crisis in Financial Markets

Financial Times (London, England)
August 17, 2007 Friday, p 9

Parallel worlds? As markets suffer, belief persists in the real economy


When Sentinel, a large American investment house, stopped investors from withdrawing their money this week, it cited market "panic". No wonder: markets around the world gyrated dramatically in recent days, contributing to a growing sense of crisis in parts of the financial world.

But what has been almost as remarkable as this month's market turmoil is the reaction of economists: unlike their -panic-stricken counterparts on bank trading floors, the pundits paid to analyse the "real" economy have been saying: "Crisis, what crisis?"

Certainly, the current market turmoil originated with a "real" economic woe - the all-too-tangible problem of some financially stretched American households failing to make mortgage payments. But this summer it spawned a drama in esoteric and acronym-rich spheres such as the collateralised debt obligation (CDO) market, the asset-backed commercial paper (ABCP) world, or the sector of special investment vehicles (SIVs).

The million - or trillion - dollar question now is whether the financial crisis will return to haunt the wider economy or whether it can be contained. Are these market troubles, in other words, unfolding in a parallel universe inhabited by over-excited bankers and hedge fund managers; or are we witnessing a "time-lag" problem, meaning that the damage from the financial crisis is very real but has yet to feed through to the "real" economy?

Many of the financiers at the heart of the current storm argue - perhaps unsurprisingly - that the events are highly significant. For what is essentially occurring now is widespread -"deleveraging" - the market term for when investors and financial institutions are forced to cut their debt in a hurry by selling assets.

Financial history suggests that such deleveraging rarely occurs smoothly, or without having a knock-on effect on the wider economy. What makes this episode particularly unnerving are signs that the pain is spreading from hedge funds to banks. As George Magnus of UBS says: "Deleveraging may prove longer-lasting (than expected) and not confined to the US sub-prime mortgage market . . .Gloomier scenarios, including hard-landing risk, must be considered in the event that the ongoing financial malaise worsens and endures."

But most economists remain sanguine. After all, fundamental world growth prospects are strong, they say, and lower prices for risky assets could even make the economy more robust. Moreover, much of the market turmoil has erupted in financial spheres such as derivatives - which often appear to have a limited connection to the world of goods and services.

David Miles, chief UK economist of Morgan Stanley, for example, likens the complex financial products that are central to the current malaise to bets on a horse race. These bets can add up to an impressive figure - but they do not affect the outcome or the strength of the horse.

Similarly, he argues, in the real world it is the revenue-generating process of the economy in households and companies that matters, not the complex bets on this made between investors in sophisticated markets. Or, as Julian Jessop of Capital Economics puts it rather more directly: "People in financial markets always think they are more important than the real world."

Nevertheless, making a definitive judgment on the wider impact of the current turmoil is difficult, partly because the events unfolding in the financial sphere are highly complex - and still moving so quickly that policymakers often struggle to piece together what is going on.

Two important facts exist. First, markets have been so calm in the past few years that the level of returns investors could earn on their assets was low. Consequently, many scrambled to find new ways of boosting these returns - and one easy strategy has been to assume more debt to buy assets, pushing up their values and increasing risk at the same time.

Second, there has been a frenetic burst of financial innovation. This decade, bankers have created a plethora of new ways to slice and dice the types of risk that used to be held on banks' balance sheets - and sell them on to new investors. The subprime mortgage market is a case in point: banks used to hold these loans on their balance sheets but in recent years have turned them into bonds and sold them to new investors - who typically then use them to create derivatives, which are then repackaged and resold, over and over again.

Judging just how much indebtedness has been created as a result is hard, since many of these new-fangled instruments are relatively opaque. Worse still, the investors that have raised their leverage - such as hedge funds and SIVs - typically operate partly outside the realm of the regulated banking system.

Nevertheless, what is clear amid this fog is that the unravelling of leverage now under way is brutal. For while the process started with a tangible and seemingly limited problem - namely defaults on US subprime loans - as funds have rushed to offload these assets, this has triggered waves of selling in other markets such as equities.

Nobody expects to see this process end soon. "We see markets on a knife-edge for the near term," admits Jan Loeys of JPMorgan. One reason is that there is now rising uncertainty about where the subprime losses actually lie. For the same process that created this decade's financial exuberance - namely the ability to slice and dice risk - means that exposure to subprime losses is spread widely around.

As a result, investors are now being confronted by a series of nasty shocks - or "small grenades", as one policymaker calls them - as institutions keep unveiling more bad news. This process could last for some time, given that the institutions holding subprime debt employ a vast array of practices for measuring the value of their portfolios - which means many will only acknowledge their hits after a long delay.

A second factor fuelling the unease is that there are now signs that problems are spreading from hedge funds and other small players to banks themselves. One link between the markets and the banks is via another key institution that has been purchasing complex securities linked to US mortgages: the so-called SIV or conduit, a vehicle that funds itself in the short-term money markets and thus does not appear on the banks' balance sheets. However, many of these vehicles have arranged emergency credit lines with banks in case their normal funding sources dry up.

The fear haunting the markets now is that the banks will soon be forced to bail out these vehicles, which could place bank balance sheets under huge strain. In fact, this has already occurred at one German bank, IKB, which triggered a near-implosion. "Credit market conditions are now analogous to a secondary banking crisis," notes Tim Bond, an analyst at Barclays Capital. Stress on the banks might potentially force them to call in lines of credit to the real economy, cutting into growth, as has occurred in previous banking crises.

Nevertheless, there are some reasons to be sceptical. A key point about the frenetic pace of financial innovation is that it is financial players - not mainstream companies - that have generally become highly levered. Thus, while interest rates have been low, the remarkable record of world economic growth over the past four years - the best run in over 30 years - has not been on the back of a corporate borrowing binge, fuelling investment in worthless assets.

On the contrary, corporate debt in aggregate has been falling and balance sheets growing ever more healthy. As a result, the cost of borrowing for companies with stronger finances, and even for those with junk bond ratings, has generally been flat or even falling over the past month, irrespective of the turmoil (see chart). Similarly, creditworthy households have been enjoying a period of falling long-term interest rates, which is far from recessionary.

The one area where growth has been fuelled by excess borrowing has been in US subprime mortgages. But the net economic losses are too small to put a big dent in US growth, let alone the global economy. The Federal Reserve, for example, currently estimates that net losses from subprime will be between Dollars 50bn (Pounds 25bn, Euros 37bn) and Dollars 100bn. But Lehman Brothers points out that even losses of Dollars 200bn would be "far less in nominal terms than the half-trillion US savings and loans debacle of the mid-to-late 1980s". It adds: "As a per cent of the world bond market, this is about five-tenths of one per cent; a large absolute number but small on a relative basis."

Indeed, policymakers may even -welcome what is occurring. After all, central bankers around the world have repeatedly warned over the past year that markets were pricing risky credits too cheaply. Thus, as Jean Claude -Trichet, the European Central bank president, pointed out this week, one upside of current events is "a normalisation of the pricing of risk". Mervyn King, the governor of the Bank of England, went further last week, calling the events "a more realistic pricing of risk, and that's to be welcomed".

If credit does become more "normally" priced, this will benefit anybody who has not become over-levered in recent years. In the corporate world, for example, mainstream companies are now better able to compete against buy-out rivals. "Deleveraging an overleveraged system is always dangerous," notes Credit Suisse. "(But) better to deleverage when in a strong economy than a weak one . . . when there are plenty of strong cash buyers waiting in the wings (and) when past over-investment is not threatening a profits bust."

However, the longer the turmoil lasts, the greater the potential risks to business and consumer sentiment - and the wider economy. If a serious crisis erupts at a bank, for example, that could dent confidence. Similarly, if creditworthy investors - companies with healthy balance sheets or consumers with unblemished credit histories - cannot borrow at reasonable rates, this may slow growth. But these remain for the moment just "ifs" - and there are no signs of it yet.

A more tangible threat is that US households will now respond to the turmoil by raising their levels of saving in response to slower growth or even future falls in house prices. That could reduce US growth prospects and has been an economic risk, unrelated to the current credit market woes, for some time. Meanwhile, in the very near future, a prolonged period of deleveraging could hurt the financial services sector. Jobs and house prices in London and New York, for example, may yet be hit.

But much depends on whether households and companies ignore the fear in capital markets as an obscure event with little bearing on their prosperity and prospects or whether they see this as a portent of harder times to come and hunker down. And it is these risks - not a desire to bail out the financial markets - that are giving central banks pause for thought. In Europe, the ECB is still likely to raise interest rates again, while the Bank of England looks as though it will now wait and see. In the US, the Fed is still more concerned about inflation than falling growth, implying that the markets are too certain about a cut in rates in September, but it would respond to evidence that prolonged troubles for borrowers was damaging the economy.

But at the moment, the focus among policymakers remains on trying to smooth the necessary adjustment to a more deleveraged world in the markets - so that the badly needed repricing of risk can continue without wider disruption. The aim, in other words, is to ensure continued growth without bailing out those who have lent or borrowed unwisely. And if central banks deliver this - and it remains a big "if" - it will be a true measure of maturity and -success in the global economic system.

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