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Monday, December 1, 2008
Poisoned by toxic debt

While the banking system in most emerging economies is not directly poisoned by the ‘toxic’ debt, the sharp increase in global risk aversion is wreaking havoc with their stock markets.

The global financial system is facing extraordinary distress. The year-long credit market turmoil has turned into a full-blown financial crisis, prompting extreme measures by governments to try to stabilise the banking system and financial markets.
Explains  Kevin Lings Economist at Stanlib, “In essence, the banking sector has three inter-linked problems namely:
• a huge pool of troubled or ‘toxic’ assets in the form of mortgage backed securities;
• inadequate levels of capital given that the values of their assets have had to be written down dramatically; and,
• a lack of funding liquidity since most banks are unable or unwilling to provide credit to other banks.

Credit spreads have widened to record levels, and volatility in financial markets has soared. “No asset class or investment market has been immune from the impact of slowing global growth and the increased risk aversion that has resulted from the global financial system crisis,” says Lings.
The following is basic explanation of how the crisis came about based on research obtained mostly from the Institute of International Finance as well as Paul Krugman, a renowned Economist in the US. It took the market just five steps to get itself into a corner.

Step 1. A housing bubble was created in the mid-2000s. While this was most evident in the US and UK markets, it was not confined to those economies. Many countries experienced sharp increases in house prices from 2002 to 2006, that far exceeded the growth in household income. This boom, especially in the US, was fuelled by:
• low interest rates;
• increased global liquidity;
• aggressive and innovative marketing of credit facilities;
• a belief that house prices would continue to move higher forever;
• the incorrect pricing of risk; and,
• a global search for higher yielding financial assets.

The growth in house prices coupled with historically low interest rates, and low levels of financial regulation fuelled a boom in sub-prime mortgage financing. The annual issuance of US sub-prime mortgage backed securities increased from a mere $56 billion in 2000 to a massive $508 billion in 2005. Sub-prime and Alt-A mortgage now comprise roughly 20% of all US mortgages.

Step 2. The US housing bubble started to unravel during 2006. This was on the back of higher interest rates, record debt levels that had been build-up over many years, record oil and food prices, and a deteriorating level of consumer confidence. The house price deflation is reflected in the fact that US house prices have been declining by 20% since their peak in July 2006. Housing markets in most other economies are also in various stages of slowdown or recession.
Lings says this is reflected in a surge in US housing foreclosures and debt defaults. In Q2 2008, the total delinquency rate for US mortgage loans on residential properties was recorded at 6.41%. This compares with 6.35% in Q1 2008, and is the highest level on record (the records date back to 1979). “Worryingly, the second quarter increase in overall mortgage delinquencies was mainly due to an increase in delinquencies for prime loans, and not sub-prime loans.” In fact, during Q2 2008, the delinquency rate for sub-prime mortgages actually decreased 12 basis points from 18.79% to 18.67%. 18.67% off, of course, an extremely high rate.

Step 3. The weakness in the US housing market led to a dramatic fall-off in the prices of mortgage backed securities since ultimately the value of these assets are derived from mortgage payments. This started to become evident from August 2007, although the extent of the problem was not known at the time. The loss in value of mortgage-backed securities and other related instruments has left many financial institutions with too little capital. In other words, the value of their assets have declined relative to their debt. This problem is especially severe because most market participants took on far too much debt during the bubble years. Since the beginning of 2007 banks in the US have written off $334 billion, while European banks have lost $229 billion and Asian banks $24 billion (These losses are up until the end of September 2008). Despite the substantial mark-to-market losses already reported, owing to the scale of troubled assets, investors fear more losses are likely to materialise.

Step 4. For the past year, financial institutions have been trying to reduce their debt by selling assets, including those mortgage-backed securities, but this has simply driven down asset prices, making their financial position even worse. This vicious circle is what some key financial market participants and economists have called the “paradox of deleveraging.” Understandably, financial institutions have greatly increased their risk aversion to counterparty risk. The interbank markets have essentially seized up, with transactions mostly being done on an overnight basis. In fact, European banks have started depositing much of their funds with the ECB, instead of lending to each other. Ironically, while each bank does what is best from its own perspective, by dramatically reducing counterparty risk, together these actions have made the situation worse. Furthermore, since financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the level of credit the economy needs. “This is leading to sharp downward revision to global economic growth,” Lings remarks, “with some analysts now forecasting a global recession in 2009.”

Step 5. The US Treasury Secretary’s (Henry Paulson) $700 billion plan was finally signed into law on 3rd October. The plan, which is known as the US Troubled Asset Relief Program (TARP), is certainly a step in the right direction, although it has been heavily criticised by financial market commentators, while others have suggested alternative plans. In simple terms, the TARP calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities, over a period of time, thereby providing much needed liquidity to the US banking system. When operational the government aims to bring relief to the market for the ‘toxic’ mortgage backed securities actually bidding up the price for these assets relative to the prevailing market prices (which is extremely depressed), but still buying the assets cheaply enough to reflect the risk currently associated with these instruments. The increased liquidity coupled with the increased price would then help to recapitalise the affected banks. If this then acts as a catalyst to get other long-term funds to re-enter the mortgage market, it would have a significantly positive impact on the financial system. A stabilisation of the mortgage related markets could help to bring some calm to financial markets and create a breathing space until the US housing sector shows clear signs of bottoming out. Importantly, the TARP cannot stop directly house prices from falling, although an effort will be made to help house-owners to keep their homes.

“Ultimately, banking is a confidence game,” says Lings. The TARP bailout package as well as the various bailout actions of European governments have, as at 6th October, not yet installed sufficient confidence back into the markets. The US Federal Reserve has already provided in excess of $900 billion in additional liquidity to the financial system and stands ready to provide more liquidity. “I hope that the major central banks will shortly opt for a co-ordinated cut in official interest rates,” notes Lings, “especially the UK and Euro-area and possible the US, in order to provide general economic relief. This is made possible by the sharp contraction in most commodity prices, including oil and food prices, which substantially lessens the immediate inflation concern.
“While the banking system in most emerging markets economies is not directly poisoned by the ‘toxic’ debt,” he says, “the sharp increase in global risk aversion is wreaking havoc with emerging market investment markets.” The EMBI risk spread has already risen to 500bps compared with 239bps at the end of 2007. The MSCI Emerging market equity index is down 45% year-to-date in Dollar terms, with Russia down 63%, China down 56%, India down 52% and Brazil down 47%. SA has not fared much better, now down 43% year-to-date in Dollar terms.
“Expectations of global growth and corporate earnings are systematically being revised down, especially for 2009.” Some global analysts are now forecasting a global recession in 2009, which is still an extreme case but certainly possible. Fortunately, the global inflation risk is dissipating very rapidly as commodity prices tumble. 
“At Stanlib, during the current period of turmoil, each fund manager/franchise has obviously opted to manage his portfolio in-line with how he sees the situation unfolding.” Adds Lings, “There is not necessarily a uniform approach, which is the nature of the franchise system.
“Some managers have opted to reduce their equity content heavily and raise cash, while others have taken a long-term approach. Most managers have maintained a large offshore component within their portfolio in order to benefit from the currency weakness.”

Copyright © Insurance Times and Investments® Vol:21.11 1st December, 2008
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