Over-Leveraged Credit Markets an Accident Waiting to Happen ; BUSINESS
Davies, Gavyn, The Independent (London, England)
Markets were in free fall last week, with some equity indices (including the FTSE 100) eliminating all of their previous gains for the year.
Investors who have been holding sensible diversified portfolios did much better than those in UK equities, because international stockmarkets outperformed the FTSE, and other asset classes (like bonds and commodities) rose in value as equities collapsed. As the graph shows, balanced port-folios of global assets are probably still up by around 4 per cent this year. But if this sudden equity collapse turns into a prolonged bear market, there will be few places for anyone to hide.
A correction in risky assets has been long predicted by market pessimists, and indeed long-desired by many central bankers, who have been arguing that the risk appetite of investors has become excessive and dangerous.
Observing the behaviour of many hedge funds in the mortgage markets, it is easy to see their point. But remember that in the 1990s Alan Greenspan warned of "irrational exuberance" almost four years before the bull market finally ended. Investors who paid attention to him would have missed the second greatest bull market of the 20th Century, a mistake from which there is no swift recovery. So investment managers are forced to address the most difficult question of all - is this "the big one"?
The immediate genesis of the recent sharp correction in markets is straightforward. A bubble developed in the American housing market in 2003-05, and this has now burst with a vengeance. Although this has only reduced growth in US GDP by about 1 per cent per annum, it has caused severe problems in the US financial sector, parts of which had become severely exposed to the riskiest end of the housing loan market, known as subprime mortgages. Loans to sub- prime borrowers continued throughout 2006 and even 2007, well after the collapse in the housing market had become painfully visible, and packages of these loans were held by the investment banks, or sold to hedge funds, in new instruments called collateralised debt obligations (CDOs), which enabled investors to make leveraged bets on the health of the borrowers. When these bets proved misplaced, several hedge funds were wiped out, and the investment banks saw their share prices drop by 15 per cent or more.
So far, so messy. But none of this is enough, on its own, to spell the end of a global bull market. Estimates of the eventual losses which will be booked in the sub-prime market are generally around $100bn ([pound]50bn), while the wealth of the American household sector exceeds $60,000bn. More troubling, perhaps, is the recent tendency for sub-prime woes to damage sentiment in other high- yield credit markets, where spreads relative to government bonds have risen from about 2.5 per cent to nearly 4.5 per cent. This will increase the cost of borrowing in much of the economy, and also make it more expensive for private equity firms to use leverage in equity buy-outs.
All this could damage the stockmarket and the economy, especially if the available quantum of credit becomes restricted, as well as becoming more expensive. Academic evidence suggests that a "credit crunch" of this type can do significant economic damage.
This will undoubtedly happen for a while. Now that the credit debacle has spread beyond the mortgage market to the corporate debt market more generally, the banks will inevitably become much more cautious. They are reported to be sitting on deals worth $200-300 billion which they have underwritten, but are now unable to pass on to syndicates.
Although the losses on these loans are likely to be only a few per cent of the banks' equity (at most), the loan markets …
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Publication information: Article title: Over-Leveraged Credit Markets an Accident Waiting to Happen ; BUSINESS. Contributors: Davies, Gavyn - Author. Newspaper title: The Independent (London, England). Publication date: July 3, 2007. Page number: Not available. © 2009 The Independent - London. Provided by ProQuest LLC. All Rights Reserved.
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