The sub prime crisis : Will cuts in interests rates restore risk appetite?

Will cuts in interests rates restore risk appetite and encourage entities to take up new debt. Or will growth slow down? According to George Magnus, writing in the Financial Times, the reduced availability of cheap credit will lead to a sharp reverse in spending. Magnus also mentions that the current crisis is different from 1998 when liquidity was the main concern. This time the problem is about solvency. The rapid deterioration in financial conditions and rising cost of capital will almost certainly lead to higher default rates. Magnus expects that in the near future, the price of capital will depress borrowing, capital mobilization, capital spending and employment. While the US will be the worst hit, Europe and Japan will slow down though not so much. But overall, the world economy may lose momentum and the business cycle may get rough.

Meanwhile, there have been wild swings in prices of some of the safest and most liquid government securities. After a flight to quality, there has been a massive sell off of T Bills. On August 22, the yield on one month treasury bill rose 83 basis points to 3.15%, while the 3 month T bill yield increased by 17 basis points to reach 3.44%. Swings of 50-100 basis points in T bill yields have become quite common. These fluctuations are of course the result of serious concerns about the $2130 billion commercial paper market, 50% of which is estimated to be backed by assets such as consumer loans, including mortgages and complex structured securities such as CDOs (Collateralised Debt Obligations) Money market funds, which are usually major buyers of such paper have shifted to the much safer T Bills. Till the markets become more confident that the skeletons are out of the cupboard, uncertainty and mistrust will continue. So will the market fluctuations.

Meanwhile, a more optimistic view has been expressed by Ken Fisher again writing in the Financial Times. According to him, while credit spreads have widened, they have not widened all that much compared to credit crunches of the past. Fisher also argues that a lot of cash hoarding is taking place, a clear signal that these are the late stages of a panic or correction, not the early stages of a bear market. Even today, interest rates remain low and debt is attractive. Firms can borrow globally and buy back shares to increase EPS. If that continues, the supply of equity will shrink and the bull market will resume.

Meanwhile, shakeouts continue. On August 23, Lehman Brothers announced plans to shutdown its sub prime mortgage unit, BNC Mortgage. Lehman will take a charge of about $52 million. According to company sources, sub prime lending activities account for less than 3% of revenues in recent quarters. Some 1200 people are expected to lose their jobs.

Meanwhile, Accredited Home lenders, a sub prime lender and HSBC have announced combined job losses of more than 2000. Accredited will cut 1600 jobs while HSBC will slash 600.

On the other hand, Bank of America has plans to invest $2 billion in country wide financial, the troubled mortgage company’s current market cap of about $12.6 billion. Bank of America’s move indicates that some companies are seeing a big opportunity to pick up undervalued stocks even as the market turmoil continues.