Market Volatility Is Not All Bad News for Investors; the Turmoil on the World's Financial Markets and the Accompanying "Credit Crunch" Has Both Threats and Opportunities for Investors, Says Williams De Broe, the Stockbroker and Wealth Manager with a Strong Presence in Birmingham. Head of Research Jim Wood-Smith Outlines the Firm's Thinking
Byline: Jim Wood-Smith
We are currently seeing the first period of sustained volatility in world financial markets since the post-TMT bear market ended in March 2003.
Unusually, this does not appear to be rooted in fears over the US or global economy, nor is it a reaction to an obvious overvaluation of equities.
Instead, the most sensible analysis suggests that what we are seeing is a sudden change of sentiment towards the virtues, or evils, of debt.
We have all known for many months that parts of the US housing market were seeing dramatic price falls after a period of considerable excess.
What was not appreciated in markets was the extent of the greed of lenders in the so called "sub prime" mortgage sector. The tag refers to those with credit records inadequate to obtain a mortgage ordinarily, but to whom institutions have been prepared to lend in exchange for a higher rate of interest.
As house prices have fallen and as jobs have been lost in certain industries, notably construction, some sub-prime mortgagees have found themselves unable to meet repayments on properties worth less than the value of the mortgage.
This is in many ways reminiscent of the negative equity seen in the UK housing market at the start of the 1990s.
In previous cycles, the damage from this would be restricted to a small number of lenders and insurance companies. However, this time around the situation has been massively complicated by the advent of financial instruments known as CDOs - collater-alised debt obligations.
Simply, these are packages of mortgages sold by the lending originator to anyone else wishing to take on the risk of receiving the future loan repayments.
These have been hugely popular in recent years, so much so that no one now knows precisely who it is who owns these mortgages.
One supposed benefit of this was that it would reduce any potential risks by spreading these thinly amongst all and sundry. The reality, as is so often the case, has been painfully different and there is currently hardly a financial institution in the world that is not being damned by rumoured association with sub prime losses.
These same CDO's are underlying many allegedly asset-backed funds. These are seeing a crisis of confidence amongst unit holders, who do not know whether their funds are holding these non-performing sub-prime loans or not.
This has resulted in a very small number of funds receiving a hugely disproportionate amount of publicity after being forced into liquidation by unit-holders demanding their money back and forcing disposal of assets at fire-sale prices.
In some cases, confidence in the quality of sub-prime loans has evaporated completely and banks have become wary of lending to each other.
Over the past week this has pushed overnight interest rates in Europe and the US far higher than the ECB's and Federal Reserve's target rates, forcing them to issue short term liquidity into the markets.
We have to ask exactly what any of this has to do with equities?
The links are tenuous, but nonetheless significant enough to have caused the unpre-dicted and dramatic falls that we have seen over the past month.
The key is that there is a sudden demand for cash - akin to a run on the bank. …