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August 19, 2007
The image of the crisis in global financial markets is no longer that of a wrecking ball, as it was in the Asian crisis of the late 1990s. It is now that of a big wave of panic and turmoil threatening to swamp the shore of the money markets where a Darwinian ethos rules. As does uncertainty.
Moreland
This increasingly looks as if it is more than a rash of mortgage lending to Americans who were in the habit of falling behind in their mortgage repayments. The loses suffered by the unregulated hedge funds are too great for that. Debt markets have tightened up. Measurable credit risk is being repriced. Banks no longer trust other investment banks or mortgage companies. Fear of the unknown is causing the market to panic.
There is little accountability in the financial system, the shadows are everywhere, and people are offloading their junk credit packages (collateralized debt obligations or CDO's) It's a classic example of market failure. Corpses, identified as those of the masters of the universe, are floating in the water.
Bernanke & Co and the US Federal Reserve have lost a lot credibility with their “subprime is contained” story. Now they are trying to sell the “housing is contained” story.
Should the Federal Reserve be bailing out hedge-fund managers? Should it reassure investors and save some money managers from well-deserved oblivion. Well that would be great for the masters of the universe on Wall Street wouldn't it.
Update: 20 August
Will the Federal Reserves recent discount rate operation re-liquify totally frozen credit markets? Can the credit problems, which are creating the market turmoil, be solved by liquidity injections? I'm not sure. Paul Krugman, in his recent It’s a Miserable Life op-ed in the New York Times, describes the situation as one in which:
many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick.
He comments that the problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to ... old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks.
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Gary,
Clearly last week's liquidity crisis in the US and Europe was one of the ramifications of the popping of the US housing bubble.
The rising housing market was the mainstay of the U.S. economy following on from the dot com stock market bubble meltdown in 2000. Of course the recession was held off (postponed?) by dropping interest rates down to 1%. A lot more hot (speculative) money entered the real estate market inflating prices. Some of this cheap money (interest rates below the real rate of inflation?) was channeled into sub prime mortgages.
I read that Moody's had rated a lot of the sub prime mortgage backed bonds as AAA. Sarkozy criticised them for not accurately rating the bonds, however he was defending the now tainted reputation of the European banking establishment - scammed by the Americans to the tune of hundreds of billions of dollars. The bank owned investment funds that bought the bonds were fully aware of the risk however the bonds were asset backed and in a rising market they had little to worry about. If the mortgagee got into trouble the real estate would be sold (at a higher price than bought) to pay off the debt and the mortgagee was likely to walk off with a capital gain.
When the market tanked and did not recover the investment funds holding the bonds would have become concerned about the value of the assets backing the bond paper. With the market being depressed for sometime now, and sub prime mortgagees defaulting in large numbers the bonds became hard to unload. The associated risk is hard to price because of the uncertainty over how much sub prime debt will be defaulted and the real value of the assets backing the debt going into the future. Banks will normally only lend up to 85% of the purchase price to cover themselves against price declines, most include insurance, however I read that many sub prime mortgages were issued without any of these protective measures.
It was interesting to see how the ECB and the US fed reserve handled the liquidity crisis last week. We can be sure that the lights remained on well into the night in Paris, New York, Frankfurt, Rome, etc, while banks responded to the Fed/ECB call to assess their exposure (locked up capital) to sub prime US mortgage debt (confidentiality assured of course). It was like the ECB was calling for a show of hands so it could identify the dumb and the stupid. Most came forward and where assisted (bailed out) to the tune of 95 billion Euros. The next day more came forward and even more funds had to be released.
I think it's fair to say that the European and Asian banking elites have been of the view that US monetary policy in recent years has been reckless and irresponsible. After this unpleasant incident the US credit market is going to find it harder to attract offshore funds. In the current environment both institutional and private investors will be more cautious and demand higher returns. As an example, day after day last week the CEO of RAMS declared that their loan book was rock solid, 100% insured with few defaults, however in the market they still couldn’t find any takers to fund their debt.