Global Trends by Martin Khor

Monday 25 February 2008

Credit crisis spreads to new areas

The debate goes on whether the United States will fall into recession, but on the ground the bad news is that the credit crisis is spreading to new areas, threatening more losses and a reduction in credit to consumers and companies.

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There have so many reports about the recession in the United States, so it was surprising to read last Saturday that only 45% of business economists in the US believe a recession will take place this year.

The median forecast of these business economists (who work in companies) is that the US would have slow economic growth of 0.4% in the first quarter, which would then pick up to 1% in the second quarter and 2.8% in the third and fourth quarters of this year.     

If this happens, it would be good news. A couple of quarters of slow growth would actually be a relief, given the recent more gloomy forecasts.

On the other hand, the past week has also brought worrying reports showing that the financial crisis is spreading to other areas. 

The crisis began in the “sub-prime” house mortgage sector in the US.  It then spread to many banks in the US and Europe which had invested in financial instruments linked to the value of these sub-prime mortgages. 

Some of the world’s biggest banks, like Citigroup, Merrill Lynch, UBS, Morgan Stanley and HSBC, lost many billions of dollars and some had to restore their balance sheets through massive injections of equity, mainly by sovereign funds from the Middle-East and Asia.

Then the crisis spread to firms in other areas.  Two weeks ago came the news that a big company that insures bonds had got into serious trouble.  The Financial Guaranty Insurance Company lost its triple-A credit rating, due to guarantees it had made on structured securities, and this raised serious questions about whether it could meet obligations on US$220 billion of municipal bonds that it had also guaranteed.

Regulators in New York have been trying to prevent a municipal bond crisis that would increase the funding costs for municipal borrowers in the US.  Many banks that bought insurance from FGIC on mortgage-backed securities and collateralized debt obligations are likely to take on more losses.

Last week, the New York Times (NYT) and the Wall Street Journal (WSJ) reported on another potential crisis in the huge market in securities that insure against defaults on companies’ credit, which are known as “credit default swaps.”

The NYT of 17 Feb. explains how this market works.  The swaps are a set of new financial instruments that are supposed to cover losses to banks and bondholders when companies default on their debts.  The markets for these securities have grown huge, from US$900 billion in 2000 to over US$45 trillion today, or twice the size of the US stock market.

In a credit default insurance, a corporate-bond investor seeks protection (buys insurance) against default of an asset he owns, or a speculator (who is not an owner of the asset) uses the swap to bet on the company’s health.  The seller of the insurance is a bank or insurance firm or hedge fund which receives premiums from the insurance buyer and promises to pay him if he defaults on his debt.

But this seller in turn assigns the insurance contract to another party which in turn can assign it to other parties and so on. The problem is that if a default happens, the buyer of the insurance may have difficulties tracking down who now holds the contract and is thus responsible to pay up.

The article concludes that as defaults kick in and events unfold, it will be shown who has managed well and who has not.

The credit-default swap problem is further explained by the WSJ of 22 February, which said that “the global financial squeeze is spreading to investments linked to the corporate-debt market, slamming the value of contracts that provide insurance against defaults and marking one of the first times that the debt of major companies has been affected by the turmoil.”

It added that investors in credit-default swaps have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes have doubled since the start of the year, meaning investors who sold this insurance suffered losses.

“The indexes' moves could prove to be self-fulfilling prophecies, causing heavy losses for investors and making it even harder for people and companies to borrow money. Adding to the anxiety, analysts can only guess at the volume of investments tied to the indexes, who is holding them and what it would take to trigger a full-scale sell-off,” said the WSJ article.

As of 21 Feb, the annual cost of five years of insurance against default on $10 million in bonds on the CDX index (which tracks North America companies) had risen to $152,000 from $80,970 at the start of the year.

The cost of Euro 10 million of insurance on the iTraxx index (which tracks the cost of insuring 125 debt issues by European companies) had rose to Euro 123,750 from Euro 51,320 at the beginning of the year.

A rise in the cost of insurance means a loss for investors who sold insurance, because the only way to get out of these investments is to buy another insurance policy to replace the policy they sold in the first place.

”Even in the absence of greater defaults, the moves in the indexes can cause a great deal of havoc, triggering a downward spiral in which the forced unraveling of complex investment products drives ever-larger losses for investors and rises in the cost of insurance, which in turn could ultimately drive up borrowing costs for companies all over the world,” said the WSJ article.

With this kind of extra financial crisis looming in the wings, it may be overly optimistic for the business economists to predict “no recession” this year in the US.