Global financial markets are in a state of turmoil as a result of a mortgage loan crisis originating from the US. Uncertainty prevails as no one knows how massive the losses in the US housing market will be and how extensively it has affected (and will affect) financial institutions across the globe. It remains to be seen how this financial crisis will play out and whether it will trigger a global economic downturn.
Martin Khor*, Third World Resurgence # 203/204, July-August 2007.
UNCERTAINTY and volatility in financial markets across the world appears likely to persist as more news emerges on banks and funds hit by the losses and the mess originating from the ‘sub-prime’ mortgage market in the United States.
The uncertainty arises from lack of information on which institutions are affected, and thus on where it is safe or unsafe to invest in. A major problem is that the effects have spread far beyond the institutions that are directly hit by losses caused by the US sub-prime mortgage markets. Since investors do not know which institutions are in trouble, there is a general loss of confidence and a rising demand to redeem their investments in equity and hedge funds, including in those that were not directly hit by the sub-prime mortgage crisis.
As the funds face higher redemption demands in their home countries, they have to pull their money back from investments they have made abroad, for example in stock markets in Asia.
The ‘carry trade’
Another complication is the ‘unwinding’ of the ‘carry trade’, in which funds have borrowed heavily in Japanese yen (that carries low interest rates) to invest or lend in assets in countries with higher interest rates. The current crisis has increased the value of the yen, thus reducing or wiping out the advantage gained in the difference in interest rates by the ‘carry traders’, since more of the currencies invested in has to be spent when buying back yen to repay the yen-denominated loans.
The hedge funds and others involved in the carry trade have started ‘unwinding’, by selling off their assets in countries with high interest rates, and returning their yen-denominated loans.
‘The carry trade, particularly using the low-yield yen, has been a huge source of funding for speculative trades across asset classes,’ according to a Financial Times article. But now the yen is surging as traders take bets off the table. ‘All of a sudden, the carry trade is frightening and a big sell,’ it quoted a financial analyst.
As the yen carry trade unwinds, and more yen is in demand to pay back the loans, this sends the Japanese currency’s value even higher, which in turn makes it more urgent for more ‘unwinding’ to take place. These two factors – higher redemption demand and the unwinding of the carry trade – may account significantly for the shares selloff in at least some of the Asian stock markets.
An article in the International Herald Tribune on 18 August said that ‘the market volatility created by the unwinding of carry trades, which has ripped through all kinds of assets, is something most people can do without. And it feeds on itself: volatility in exchange rates makes cheap-yen borrowing increasingly risky, necessitating more unwinding…
‘Many of the market declines are the result of forced selling by fund managers. As investors lose money, they begin to cash in their holdings in funds, forcing managers to sell stocks even if they do not believe it is wise to do so.
‘Falling asset prices compel many brokers to ask investors to deposit more cash, which forces more investors to sell their holdings to raise cash. All this selling exacerbates the pace of declines, creating a vicious cycle in which more selling begets even more selling.’
The financial volatility originating from the United States’ mortgage market has widened and spread across the world, hitting more sectors like stock markets and investment funds operated by banks.
Central banks in Europe, the United States and Asia have taken action to pump hundreds of billions of dollars into their banking systems, in an attempt to prevent the conversion of a liquidity shortage into a full-scale credit crunch and, eventually, an economic recession. The US Federal Reserve also cut its discount rate (the rate at which it lends to banks) by 0.5 points to 5.75%. However, there will most likely be more turbulence in the days and weeks ahead, as evidence of the damage caused to more financial institutions by the market turmoil emerges.
The intervention by a conservative institution like the European Central Bank (ECB) was so unexpected and stunning that a Financial Times columnist wondered whether ‘there is something truly nasty lurking out there in relation to credit losses that only the ECB knows about.’
The actions showed up the seriousness of the situation, as more financial institutions showed signs of being hit by the crisis that started in the sub-prime house mortgage sector in the US. Banks and funds that lent or invested in that sector have suffered losses, and other institutions that are linked to these have also suffered secondary effects.
One of the biggest shocks has been the announcement on 9 August that the big French bank BNP Paribas had stopped withdrawals from three of its investment funds, which were exposed to the US sub-prime mortgage market.
The crisis has thus now affected the investing public, which is unable to redeem their investments from the affected funds.
The bank said that the freeze on the funds was due to the ‘complete evaporation of liquidity’ in certain market segments in the US (meaning that there were no buyers). The combined value of the three funds was 1.6 billion euros, down from 2 billion euros on 27 July.
Other investment funds have also been hit, according to the Financial Times. The North American Equity Opportunities fund run by Goldman Sachs fell 12% in July and another 12% in August so far. The big hedge fund Renaissance Technologies is also reported to be experiencing difficulties.
The Dutch investment bank NIBC on 9 August also reported 2007 first-half losses due to exposure to the sub-prime market. In early May, the Swiss bank UBS announced that its affiliated fund Dillon Read had lost 150 million Swiss francs on US sub-prime investments.
The most publicised European institution hit by the sub-prime crisis is the German bank IKB, whose affiliate Rhineland Funding had bought 14 billion euros of bonds in the US, some backed by US sub-prime mortgages.
Massive losses from its operations led to a German government-organised rescue including a 3.5 billion euro bailout plus 14.6 billion euros in liquidity guarantees, to be shouldered by other German banks. The chief German financial regulator said that there was risk of the worst financial crisis since the 1930s.
The irony is that IKB had earned the praise of the rating agency Moody’s in December 2006, for successfully diversifying its business activities outside Germany.
In the US, the bank Bear Stearns in early July closed two hedge funds after nearly total losses on bets on the sub-prime market worth over $20 billion.
Other institutions to have been hard hit included the US’ biggest mortgage lender Countrywide Financial, which was reported by a rating agency as facing possible bankruptcy; the KKR financial firm disclosed it may lose up to $250 million due to the mortgage crisis; a Goldman Sachs hedge fund lost $1.8 billion and required an internal rescue; Canadian bank CIBC had to write off C$290 million; and an Australian hedge fund (Basis Capital) with $1 billion revealed it had lost 80% of its value.
The turmoil of the last few weeks has led to uncertainties as to what lies ahead, and how the crisis will play out.
‘Investors are finding it hard to deal with two big uncertainties,’ said a Wall Street Journal
column. ‘No one knows how big the losses from US housing will eventually turn out to be, or who will suffer them.’
The economist Paul Krugman in his New York Times column on 10 August gave his view on how the drying up of liquidity can produce a chain reaction of defaults.
‘Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C – and those who do have cash sit on it, because they don’t trust anyone else to repay a loan, which makes things even worse.’
The most scary thing about liquidity crises, said Krugman, is that it is very hard for policymakers to do anything about them. The central banks can respond by cutting interest rates or lending money to banks that are short of cash.
‘But when liquidity dries up, the normal tools of policy lose much of their effectiveness,’ said Krugman. ‘Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.’
In such an environment, most analysts believe the problems are so serious that central bank measures such as pumping funds into the system and reducing interest rates may calm the markets for a few days, but the fears will return to spook the markets.
Central bankers in Asian countries have tried to calm their markets by downplaying the effects that the US sub-prime crisis will have on their economies.
The South Korean finance ministry on 13 August said that it will supply funds to the banking system if there is a liquidity shortage. It said that Korean institutions had invested $850 million in the US sub-prime market.
In Malaysia, the central bank governor said that Malaysian institutions were not exposed to the sub-prime market, that there was adequate liquidity in the system, and there was no need for any intervention.
However, news has since emerged that three Asian banks have been heavily exposed to the US sub-prime sector, raising fears that banks from the region are more vulnerable to the crisis than initially thought.
In any case, given the high degree of interdependence between different types of markets, and between different financial institutions and companies, linked through many layers of exposure, many types of financial instruments, and through many leveraged and speculative funds, Asia cannot expect to be spared the adverse effects of the crisis.
The roller-coaster ride in the financial markets thus looks set to continue into the foreseeable future.
Meanwhile, calls are being made to the financial authorities not only to act to stem the crisis but to investigate the parties responsible and to punish them.
Danny Schechter, editor of MediaChannel.org, and director of the new film, In Debt We Trust: America Before the Bubble Bursts , said that it is a matter of time before the sub-prime credit crunch is seen for what it is: ‘a sub-crime Ponzi scheme in which millions of people are losing their homes because of criminal and fraudulent tactics used by financial institutions that pose as respectable players in a highly rigged casino-like market system.’
According to Schechter, companies suspended their usual ‘standards’ and ‘rules’ and self-styled ‘due diligence’ and knowingly sucked money out of people with poor credit records. These companies are themselves imploding and collapsing worldwide.
‘This was done deliberately, with forethought and malice, a well orchestrated plan to create armies of “suckers” and steal – yes, I said it – their monies to leverage even bigger deals. Their greed had no limits, until the scheme collapsed.
‘Behind it all were the so-called “Masters of the Universe”, the wise men of Wall Street who worked behind the scenes to turn mortgage brokers and small lenders into part of what will one day be seen as a criminal network worthy of prosecution under the conspiracy laws.’
‘We should demand criminal penalties for the profiteers who started out to enrich themselves and seem to have ended up destroying the very system they misused.’
*Martin Khor is Director of the Third World Network (TWN).