Global Trends by Martin Khor

Monday 17 March 2008

Global finance faces its own tsunami

As Malaysians were engrossed last week with our “political tsunami”, another tsunami was gathering strength in the US and global financial system, with at least seven very worrying developments.


In the past ten days or so Malaysia has been facing such a drastic change resulting from the general elections that media and the public have termed it a “political tsunami.”

In the same period, the global financial system has also been experiencing a tsunami of its own.  We are living through tumultuous times, with one major problem following   another.

It culminated last Friday with the near-collapse of America’s fifth biggest bank, Bear Stearns.  The bank had to be rescued by US Federal Reserve emergency funds channeled through another bank, JP Morgan, in a desperate move to avert a disastrous upheaval in global markets.

Bear Stearns had to write off billions of dollars of losses in mortgage-related
investments, and investors had been withdrawing their funds, forcing the bank to seek the bail out.

The news on Bear Stearns sent new shivers through the stock markets, with Dow Jones falling 195 points and the S&P 500 index closing 2.1% down on Friday.  Bear Stearns’ own share price fell 47% that day, and it has lost over three-quarters of its value over the past year.

The last week has seen at least seven major developments indicating that the crisis is spiraling.

First, data was released on 7 March showing that the US lost 63,000 jobs in February, following a fall of 22,000 in January, prompting many economists to conclude the US is in a recession.

And not just a shallow, short-term dip, but a deep recession that could be the most serious
since World War II, according to Martin Feldstein, president of the National Bureau of Economic Research.  

"The situation is bad, it's getting worse, and the risks are that the situation could be very
bad," said Feldstein, adding that the chief causes are falling housing prices, job losses, and turmoil in the financial markets.

Second, the US dollar fell sharply to a record low on 13 March, going below Yen 100 to the dollar (Y99.77) for the first time since 1995, and to a record low of $1.56 to the euro on the same day.  It is expected to fall even more.

Third, also on 13 March, the spot price of gold for the first time broke through the US$1,000 level, and the price of oil (West Texas crude) reached US$111 a barrel.  The same day, Asian stock markets fell, with Hong Kong down 4.8% and Japan 3.3%.

Fourth, there is mounting evidence that the crisis has spread to hedge funds, which are facing pressures from their creditors and investors. Expect adverse repercussions as these funds “unwind” their positions in the markets in forced sales to meet these demands.

The banks that lend to the highly leveraged hedge funds are making margin calls.  To meet these demands for more collateral, the funds have to sell their securities. Nervous investors are also redeeming their shares, thus adding to the pressures on the hedge funds to sell, and in a falling market.  Their losses are thus climbing.

A dramatic sign of this was the collapse last week of Carlyle Capital Corporation (CCC), a hedge fund that is part of the Carlyle Group, one of the world’s largest equity fund groups.

CCC, which had unwisely invested in mortgage-backed securities. It revealed that up to 12 March it had defaulted on $16.6 billion of its indebtedness, and the remaining indebtedness is expected soon to go into default.

It added that its banks are likely to take possession of its remaining assets and liquidate them, after it ran out of cash to meet margin calls.

A  front-page article in Financial Times (14 March) said the markets are “grappling with mounting signs of forced sales by hedge funds driven to reduce their portfolios by lenders trying to reduce their own risk exposures.”

Chief US economist at Merrill Lynch, David Rosenberg was quoted as saying that “the credit crunch has now reached the hedge fund industry.”  Co-chief executive of Pimco Mohammed El Erian said there were signs of “a growing number of hedge funds having to go into survival mode.”   

Fifth, the cost of protection against credit default is also mounting, and this may soon trigger forced sales of structured credit instruments.

The cost of protection from credit risk is measured by two indices – in the US, the CDX index for investment grade companies; and in Europe, the iTraxx index of investment grade corporate debt.

On 10 March the CDX index jumped 15 basis points (bp) to a record 193 bp (a year ago the index was only 30-40 bp).  The iTraxx index was trading on 10 March at a record 157 bp, up from 146 bp on 7 March.

According to Financial Times (11 March):  “Structured trades based on the value of the CDX and the iTraxx are close to reaching a major inflection point.  Many complex structures including so-called constant proportion debt obligations (CPDOs) have triggers that are released when spreads widen to a certain level. This could cause such complex vehicles to begin selling into the market and push credit spreads wider still.”

The CDX and iTraxx are very close to triggering a wave of such forced sales.  Further ratings downgrades could also cause the sale of other structured credit instruments and weigh further on CDX and iTraxx, according to traders.

Sixth is the collapse of Bear Stearns.  On 11 March, the Chairman of Bear’s executive committee Ace Greenberg dismissed speculation that the bank had liquidity problems as “totally ridiculous.”  Just a few days later (14 March) it was revealed the bank had become insolvent and had to be bailed out.

And seventh is the news that the two big companies, Fannie Mae and Freddie Mac, that hold or guarantee most housing loans in the US, are also facing a crisis and that Fannie may require a government bail-out as well.  Credit Suisse has estimated that Fannie and Freddie might have to write down US$5 billion on portfolio of subprime mortgage bonds.

They have already reported large losses in the fourth quarter of 2007 – US$ 2.5 billion for Freddie and $3.6 billion for Fannie.

These seven developments (and other trends) are signs of the most serious crisis that causing the crumbling of significant parts of the US financial structure.  The impact on the real economy of production, jobs, and income will be serious, not only for the US but also the rest of the world.