Global Trends by Martin Khor

Monday 27 August 2007

Finance markets stabilize -- for now

There was a huge sigh of relief as stock markets stabilized last week, with evidence that Central Banks, especially in the United States, are committed to prevent the credit crisis from getting worse.  As bad and good news offset one another, it is still unclear how the situation in financial markets will evolve.


Those watching or having a stake in the stock markets or in the global economy must have sighed with relief last week when a semblance of calm returned after two weeks of great turbulence.

This was perhaps due mainly to the belief that the United States’ financial authorities are ready to use their powers to do something to ease the “credit crunch” situation and prevent a full-scale crisis from developing.

The U.S. Federal Reserve’s move on 17 August to reduce its discount rate (the rate at which it lends to banks) caused the Asian equity markets to surge last Monday, and the positive tide continued to the end of the week.

The stock markets in the US itself and in Europe also recovered their spirits, prompting some analysts to hope that the worst is over, and that the situation may stabilize and then improve, back to the pre-crisis levels.

Several others, however, warn that more bad news is on the horizon, that problems remain in the US sub-prime mortgage market, in the US and European money markets, and it is a matter of time before the negative effects on the real economy of jobs and income will be seen.

Indeed, almost everyone agrees it is most difficult, if not impossible, to understand accurately what the real situation is, let alone predict what will happen next.

Good and bad news have been coming, almost in equal measure.  Perhaps that is why the stock markets have “stabilized”, with some news improving the situation, and other news offsetting the gains, or vice versa.

The main steadying factor has come from indications that the US financial authorities are now taking the liquidity shortage seriously and are ready to act if there are signs that the financial turmoil spills over to threaten economic growth and jobs.

A lunchtime meeting mid-week of the Federal Reserve (Fed) chairman, the US Treasury Secretary and the Senate’s banking committee chairman led to good cheer in the markets after the Senator revealed that the Fed chairman told him he would use all the tools at his disposal to deal with the crisis.

This was taken to mean that the Fed will soon lower the key interest rate at which banks lend to one another.  A reduction of interest rates will reduce the burden on consumers (especially house buyers), improve the situation of banks that are now facing more loan defaults, and generally give a boost to demand and sales.

The Fed has been reluctant to reduce interest rates because of its fear of stoking inflation. Its key priority recently has been to keep inflation down.  With inflationary pressures still considered high, it has no reason to lower the interest rates, except to come to the rescue of the Wall Street investment firms and banks that are now facing a potential crisis.

But rescuing fool-hardy investors and firms would create “moral hazard”.  Those who gambled and lost will be let off the hook, and thus be tempted to gamble again, knowing the authorities will again come to their rescue.

Even conservative financial analysts have concluded that “Greed” more than anything else has driven the world to this brink of a global financial crisis.

In a column in last Saturday’s Financial Times, Francesco Guerrera gave the following examples of how the financial community’s “bizarre reasoning” led to the looming crisis:

n      It was twisted rationale that prompted fee-hungry bankers to take mortgage loans, bundle them together and sell them for more than their combined worth.

n      Financial engineers defied common sense to overhaul the market for commercial paper by stapling risky mortgages to previously safe securities.

n      Banks’ penchant for lending billions to buy-out funds without covenants.

“As the credit crisis unfolds, one fact has become apparent,” writes Guerrera.  “During the recent golden era, greed dislodged logic on the ‘to-do’ list of financial practitioners.”

Though not mentioned by the columnist, the “greedy” deeds that started this crisis were the willingness of financial institutions to lend to borrowers wanting to own a house on the basis of falsified data such as inflated figures on the borrowers’ incomes, which thus justified high loans.

Go-between agents arranging the loans for one side or both sides assisted in this fraudulent practice.  When interest rates steadily increased in recent years, the so-called “sub-prime” house buyers were the first that could not meet their mortgage payments. 

The institutions that lent to them are in trouble.  In turn other institutions that invested in complicated papers linked to the loans given out by the first set of institutions (and other institutions investing in other papers linked to the second set of institutions) are now facing losses.

The bad news last week included a sudden very sharp rise in the value of short-dated US Treasury bills (marked by a plunge in yields) early in the week (signifying a crisis of confidence in other markets and thus a run towards the safe Treasury bills);  China’s two largest banks reported they had exposures of US$9.7 billion and US$1.2 billion to the US sub-prime mortgage market;  reports that two other banks in Germany are in trouble caused by investment in US home loans;  a rise in mortgage payment defaults in the US; and news that a few big banks will be reporting significant losses for the second quarter.    

The good news included the reassurances reportedly made by the Fed Chairman that he would be pro-active in facing possible future crises; more injections of liquidity into its financial system by the European Central Bank; the willingness of Bank of America to inject investments into the troubled U.S. mortgage lender Countrywide Financial; an increase in sales of new houses in the US in July;  and an improvement in the “yen carry trade” situation as the recent trend of high gains by the yen against other currencies (especially US, Australia, New Zealand) was reversed.

In the next weeks, more bad news can be expected as other banks and funds reveal losses linked to the sub-prime problem, and as investors and financial institutions continue to worry about the lack of information on the value of investments and the inability to trade in many types of debt and commercial papers.

On the other hand, Central Banks and financial authorities will be on the alert to deflect problems as they arise, through continuing interventions to provide liquidity, arranging for rescues of ailing banks and funds, and possible interest rate cuts.

The system may be patched up for the time being.  It is less certain whether there will be a small or big loss for the real economy, in the medium term. And whether the patch-up job will be followed by much stronger regulations to prevent fraudulent and greedy behavior in future, or by yet another period of laxity until the next crisis arrives.