Financial hurricane from the US

Ten years ago, the Asian financial crisis sma-shed markets and economies globally. Today, another financial crisis is brewing in the US mortgage market. Is this a small problem that will soon be resolved? Is it a serious problem that will hit financial markets but not sink entire economies? Or is it a disaster that will smash the world economy?

I estimate there is a 33% chance of each scenario — small problem, serious problem, disaster. Which means there is a two-thirds chance of a serious to disastrous downswing.

History repeats itself. An economic boom for several years creates the illusion that business risks have been lowered permanently, that big loans on easy terms can be made to people earlier viewed as non-credit worthy. Imprudent lending booms to Thailand and Korea sparked the Asian financial crisis. Another imprudent boom is now roiling sub-prime mortgages in the US.

A 10-year housing boom in the US lulled mortgage lenders into complacency. They started lending 100% of the value of a house to people with poor credit histories, often inducing them with teaser low interest rates which later rose sharply. Today, house prices are falling, effective interest rates are rising, and sub-prime borrowers are defaulting. Lenders can repossess the houses, but these are now worth less than the outstanding loans. A modest rise in defaults can break a lender.

You might think the problem is limited to incautious lenders. Not so. Recent financial innovations have produced new financial products that can infect a huge range of investors. Housing loans no longer stay on the books of the mortgage lender. They are sliced into small pieces, clubbed together with medium and high quality loans, and sold to investors as high-interest packages. These have been bought by hedge funds, private equity funds, and many other specialist funds.

This spreads default risks among more financiers, and lowers the danger to the original lender. But many owners of the new financial products have no idea how much dubious muck they own. In theory, all financial products are supposed to be valued at market price, and so a falling market price is supposed to give advance warning of troubles ahead. But many new financial products are hardly traded at all, and so are valued at face value. When a fund in distress tries to sell, it suddenly finds it can get only half the face value. So, huge losses can arise without warning, and can kill a fund.

The problem is worse in the case of derivatives and other complex financial instruments that are now traded in trillions. Hedge funds and private equity funds trade in derivatives across the world, and so escape regulation by any one central bank. This enables them to borrow very heavily to invest in opaque derivatives. This is very profitable when markets are rising, but can be ruinous when markets fall.

Two hedge funds run by Bear Stearns, a US investment bank, suddenly went bust because they had invested in the sub-prime market. Bear Stearns stopped investors withdrawing money from a third fund. Meanwhile, the 10th largest US mortgage company, American Home Mortgage, ran out of cash. The sub-prime crisis spread across the Atlantic, hitting IKB, a German bank, which had to be rescued by the German government. Two funds run by Australia\’s Macquarie Bank lost a quarter of their value.

So, what started as a US problem has become global. Naturally, the price of financial companies and products has fallen sharply everywhere. Some hedge funds have been especially hard hit.

The biggest MNCs, who need billion-dollar loans for acquisitions and refinancing, suddenly find that cheap credit has dried up. Deals involving giants like Cadbury and Expedia look like being postponed or re-priced. Indian companies are going to face the same heat.

Now, optimists believe in scenario one, that the problem is small. Optimistic hedge funds are buying distressed assets at a discount, hoping to make a big profit when markets recover.

Others expect scenario two — a shakeout in financial markets. Corporate profits, which have been galloping upwards for years, will level off or start falling. Indian stock markets could fall 20%. However, equilibrium will be restored at a somewhat lower level of corporate profitability and lending. In this scenario, the real economy will be dented but not seriously damaged.

In scenario three, panic sets in and everybody tries to sell at the same time. So asset prices crash, causing the serial bankruptcy of many huge funds. Millions lose their savings, investment and consumption shrink, and this causes a global recession.

Jim Reid of Deutsche Bank says, \”While the fundamentals, such as gl-obal growth and corporate balance sheets, are at their best for arguably decades, the technicals are as bad as we\’ve ever known them, and arguably the worst in the era of leveraged finance. Never has so much money been thrown at and been levered up in credit, and never has there been such a liquid derivatives market to hedge risk.\”

That\’s pithily put. You can still hope for the best. But be prepared for the worst.

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