The domino effect
Trying to find reasons for the recent market turmoil, there remain at least three problems. First, few predicted the scale of the turmoil. Second, any explanation only works with the benefit of hindsight. Third, it is all too easy to make reassuring...
Trying to find reasons for the recent market turmoil, there remain at least three problems. First, few predicted the scale of the turmoil. Second, any explanation only works with the benefit of hindsight. Third, it is all too easy to make reassuring comparisons with previous episodes forgetting that those, too, were equally bewildering at the time. Nevertheless, useful frameworks exist to explain both the general principles and specific mechanisms that led to the latest market carnage.
The general principles are best understood with reference to the Manias, Panics and Crashes described by the late historical economist Charles Kindleberger. Manias are a recurring feature of capitalist life, whether they involve tulips, South Sea bubbles or the 1980s Japanese stock market. The latest mania stemmed from a boom in the US housing and the related rapid innovation of housing-related financial products. The mania, in turn, was triggered by at least two separate monetary influences.
The first, intentional, influence was the decision by the US Federal Reserve to set interest rates at remarkably low levels in the early years of this decade. Back then, with equities collapsing and companies overburdened with debt, deflation seemed to be a major risk. To avoid this, the Federal Reserve encouraged households to borrow, thereby keeping overall demand at a healthy level.
The second, not so obvious, influence was the extraordinary rise in foreign exchange reserves held by emerging market central banks. These have been mostly invested in "safe" assets such as US government paper. Higher demand for these assets led to lower yields. Other investors were forced to look elsewhere to achieve decent returns. Some of their funds were poured into financial products associated with the US housing market.
In response to the interest rate increases over the last couple of years, the US housing market began to wilt. Until the last few weeks, however, the problems seemed to be relatively well-contained. In particular, US consumers still seemed happy to spend, suggesting the absence of a traditional negative wealth effect. However, the focus on the health or otherwise of the US consumer may have diverted attention away from problems elsewhere. Those taking the hit for the housing slump are not the debtors - those households who borrowed as if there were no tomorrow - but, instead, the creditors, who are now finding it a lot more difficult to get their money back.
The creditors' problems are related to an important aspect of manias. Too often, manias are associated with poorly-understood financial innovations. And in recent years there have been plenty of these, ranging from so-called sub-prime mortgages to collateralised debt obligations (CDOs).
There is nothing wrong with financial innovation per se. However, if the risks are poorly understood, these innovations can too easily be mis-priced. As a new financial product becomes generally accepted, so its liquidity begins to improve. With more people owning the product, there are more potential buyers and sellers, and hence fewer price lurches. This reduction in volatility suggests that the "riskiness" of the product is slowly falling over time.
Sub-prime mortgages are relatively high risk, provided to those who are more likely to default. These mortgages are bundled together and sold on the capital markets. They offer a higher yield for the obvious reason that the risk is also higher. CDOs, meanwhile, are structured investment vehicles typically used to invest in a range of bonds. The investors in CDOs are grouped into tranches, ranging from those holding so-called equity tranches (very high risk but typically very small) to those with very safe bank debt and AAA-rated paper tranches.
Normally, all the investors would hope to get something back from the CDO. However, should the CDO fall in value, the first to suffer the consequences will be those holding the equity tranche, followed by other lowly-rated tranches. Only if things get really bad will those with the least risky tranches be hit.
Sadly, things have got really bad. CDOs are supposed to invest in a range of assets, lowly correlated against one another, thereby implying that losses in one asset will not spread to losses in the CDO as a whole. However, parts of the CDO market that grew particularly rapidly in recent years were, it seems, too heavily focused on sub-prime, precisely the assets that collapsed in value.
The holders of these particular CDOs discovered that the assets underpinning their investments were, in some cases, not much more than toxic waste - and the ratings agencies did little to warn of the incipient dangers.
Most commercial banks have set up off-balance sheet vehicles, commonly known as conduits. These issue commercial paper in exchange for investments in a range of financial assets including credit card debt and car loans. There is nothing wrong with any of this. Sadly, though, a few conduits have invested too heavily in precisely those CDOs now collapsing in value.
The investors (insurance companies, pension funds) who previously would have bought the asset-backed commercial paper used to fund these CDO purchases now have an overwhelming sense of revulsion, forcing many of the banks to fund the conduits themselves, diverting liquidity away from other destinations.
Those other destinations include hedge funds which, faced with a squeeze on liquidity, become forced sellers of other, perfectly good, assets like equities. Thus an esoteric problem has now turned into a major financial crisis.
So far, other sectors of the economy - notably the corporate sector - appear to be in good shape. Following the Federal Reserve's actions to cut the discount rate and to hint at cuts in Fed funds to come, central banks now recognise the seriousness of the problem.
At this stage, though, it is not obvious that interest rate cuts alone will be enough to do the trick. With so much toxic waste feared to be floating around the system, with banks no longer confident of the creditworthiness of their customers (including, of course, other banks), and with the insurance companies and pension funds previously happy to buy commercial paper now on strike, parts of the global economy are suddenly looking rather fragile.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
The general principles are best understood with reference to the Manias, Panics and Crashes described by the late historical economist Charles Kindleberger. Manias are a recurring feature of capitalist life, whether they involve tulips, South Sea bubbles or the 1980s Japanese stock market. The latest mania stemmed from a boom in the US housing and the related rapid innovation of housing-related financial products. The mania, in turn, was triggered by at least two separate monetary influences.
The first, intentional, influence was the decision by the US Federal Reserve to set interest rates at remarkably low levels in the early years of this decade. Back then, with equities collapsing and companies overburdened with debt, deflation seemed to be a major risk. To avoid this, the Federal Reserve encouraged households to borrow, thereby keeping overall demand at a healthy level.
The second, not so obvious, influence was the extraordinary rise in foreign exchange reserves held by emerging market central banks. These have been mostly invested in "safe" assets such as US government paper. Higher demand for these assets led to lower yields. Other investors were forced to look elsewhere to achieve decent returns. Some of their funds were poured into financial products associated with the US housing market.
In response to the interest rate increases over the last couple of years, the US housing market began to wilt. Until the last few weeks, however, the problems seemed to be relatively well-contained. In particular, US consumers still seemed happy to spend, suggesting the absence of a traditional negative wealth effect. However, the focus on the health or otherwise of the US consumer may have diverted attention away from problems elsewhere. Those taking the hit for the housing slump are not the debtors - those households who borrowed as if there were no tomorrow - but, instead, the creditors, who are now finding it a lot more difficult to get their money back.
The creditors' problems are related to an important aspect of manias. Too often, manias are associated with poorly-understood financial innovations. And in recent years there have been plenty of these, ranging from so-called sub-prime mortgages to collateralised debt obligations (CDOs).
There is nothing wrong with financial innovation per se. However, if the risks are poorly understood, these innovations can too easily be mis-priced. As a new financial product becomes generally accepted, so its liquidity begins to improve. With more people owning the product, there are more potential buyers and sellers, and hence fewer price lurches. This reduction in volatility suggests that the "riskiness" of the product is slowly falling over time.
Sub-prime mortgages are relatively high risk, provided to those who are more likely to default. These mortgages are bundled together and sold on the capital markets. They offer a higher yield for the obvious reason that the risk is also higher. CDOs, meanwhile, are structured investment vehicles typically used to invest in a range of bonds. The investors in CDOs are grouped into tranches, ranging from those holding so-called equity tranches (very high risk but typically very small) to those with very safe bank debt and AAA-rated paper tranches.
Normally, all the investors would hope to get something back from the CDO. However, should the CDO fall in value, the first to suffer the consequences will be those holding the equity tranche, followed by other lowly-rated tranches. Only if things get really bad will those with the least risky tranches be hit.
Sadly, things have got really bad. CDOs are supposed to invest in a range of assets, lowly correlated against one another, thereby implying that losses in one asset will not spread to losses in the CDO as a whole. However, parts of the CDO market that grew particularly rapidly in recent years were, it seems, too heavily focused on sub-prime, precisely the assets that collapsed in value.
The holders of these particular CDOs discovered that the assets underpinning their investments were, in some cases, not much more than toxic waste - and the ratings agencies did little to warn of the incipient dangers.
Most commercial banks have set up off-balance sheet vehicles, commonly known as conduits. These issue commercial paper in exchange for investments in a range of financial assets including credit card debt and car loans. There is nothing wrong with any of this. Sadly, though, a few conduits have invested too heavily in precisely those CDOs now collapsing in value.
The investors (insurance companies, pension funds) who previously would have bought the asset-backed commercial paper used to fund these CDO purchases now have an overwhelming sense of revulsion, forcing many of the banks to fund the conduits themselves, diverting liquidity away from other destinations.
Those other destinations include hedge funds which, faced with a squeeze on liquidity, become forced sellers of other, perfectly good, assets like equities. Thus an esoteric problem has now turned into a major financial crisis.
So far, other sectors of the economy - notably the corporate sector - appear to be in good shape. Following the Federal Reserve's actions to cut the discount rate and to hint at cuts in Fed funds to come, central banks now recognise the seriousness of the problem.
At this stage, though, it is not obvious that interest rate cuts alone will be enough to do the trick. With so much toxic waste feared to be floating around the system, with banks no longer confident of the creditworthiness of their customers (including, of course, other banks), and with the insurance companies and pension funds previously happy to buy commercial paper now on strike, parts of the global economy are suddenly looking rather fragile.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.