The Sub Prime crisis-How legitimate are the fears of a crash?

(Ref: Gillian Tett, Financial Times August 17)

An insightful article by Gillian Tett in the Financial Times dt. 17 August 2007 mentions that the current market turmoil cannot really be called a crash. We have not seen a big drop like what we did after the dotcom boom of 2000, say. The article then goes on to cover the various concerns arising out of the market turmoil.

Is the turmoil a prelude to a bigger bear market? There is no doubt that the contagion is spreading. Initially, defaults were rising among American households with bad credit histories who had taken out mortgages – i.e., the “subprime” sector. This hit the debt markets because mortgage loans were repackaged into new securities and sold by banks to new investors. When US homeowners defaulted, the value of these related securities suffered.

Then came the hedge funds who bought sub prime securities. These hedge funds, typically borrowed money from investment banks. When these funds suffered losses on their sub prime securities earlier this year, banks asked them to funds post more “collateral”. At the same time, some hedge fund investors started to demand their money back. So hedge funds came under pressure to raise cash in a hurry. Some responded by cutting their risky strategies and conducting firesales of their assets. This is how the contagion is spreading to other markets.

When things go wrong, many things often go wrong at the same time. That is what seems to be happening now. In the past couple of weeks, the computer models that some hedge funds use to make trades have gone haywire. These models typically scan markets to spot tiny price discrepancies, and accordingly place large orders. Under normal market conditions, this technique often produces great results. But in recent weeks it appears to have triggered a flurry of equity sales, which has not only hurt the markets, but also created big losses at some hedge funds.

Now the concerns are shifting from hedge funds to banks. True banks have sold subprime securities to other investors, which means they are not directly affected. But banks have also promised to provide credit lines to other institutions with subprime exposure, such as mortgage lenders, if those institutions have problems raising finance in the financial markets. Right now, some of those secondary groups are facing funding woes, making it likely that they will soon demand credit lines from the banks.

True most of the global banks have very strong balance sheets. But what makes the situation very intriguing is that they are under pressure right now from several sources. For example, banks have arranged loans to risky companies, such as private equity buy-out groups. They are now finding it hard to sell these loans because investors are so nervous. That means an estimated $300bn worth of unsold loans are sitting on their balance sheets. And, these pressures are coming at a time when banks themselves are facing problems raising funding in the money markets.

Indeed, raising funds has suddenly become more difficult, creating serious liquidity problems. Investors in the money markets are very nervous about lending money to anybody who might be potentially exposed to subprime losses! And because of financial innovations and slicing and dicing of risks across the financial system, it is hard to know who is holding subprime exposure. So anyone looking for funds is being punished in an indiscriminate fashion without seriously examining the fundamentals.

Central banks are now getting involved. Last week, the European Central Bank pumped liquidity into Europe’s overnight money markets. The Fed, has also sprung into action cutting a key discount rate by 50 basis points. The Fed has promised to pump even more money into the market, to help the banks get access to funding. It has also signalled its willingness to take even more dramatic steps, in the future. But we don’t know yet whether all this will be enough to ensure that the money markets will work normally again or stop investors worrying about where the losses on subprime loans now lie.

One way to understand the market turmoil is to see it as a period during which investors and institutions cut their debt levels. De-leveraging a financial system is never easy, and financial history suggests this often leads to economic shocks. However, in many ways, de-leveraging is good news. For in recent years, debt levels have become unhealthily high in parts of the financial world, because the cost of borrowing money has been quite low.

What might make the current bout of de-leveraging less painful than before is that it is not mainstream companies that are burdened with excess debt. Instead, the pain is now being felt in hedge funds or private equity groups. Meanwhile, the “real” economy has been performing pretty well recently. In theory, this according to the optimists should provide some cushion against these market shocks. Will the optimists be proved right? That is the billion dollar question staring at the markets.