Re-emergence of Risk – Current Market Turbulence

At the end of July, the Australian share market posted yet another all time high. It had returned more than 15.5% since the start of 2007. A little over a week later the Australian market had dropped 7.5%, and markets around the world were falling sharply.

The falls have continued as the sub-prime mortgage dramas in the United States continued to have an impact. In this lowdown, ipac explains the current turmoil and provides a future outlook.

It started with easy money

The problems in the US mortgage market did not appear overnight.  The seeds of the crisis go back to the very easy liquidity conditions that prevailed in the US and globally in the period between 2000 and 2003. Interest rates globally were slashed, with the US Federal Reserve reducing rates aggressively.

When the US Federal Funds rate was 1%, it was below the CPI. It was cheap to borrow for business and consumers. While rates subsequently climbed back up, conditions remained relatively “easy” for several years. This was good news for the economy and served to underpin the economic growth observed over the past four years. However, low interest rates and easy liquidity, led to excesses which included larger loans and weaker lending standards with poorer security. At the same time there was an increased willingness to accept this credit risk for an additional yield well below the long-term average.

Between 2000 and 2006, the proportion of loans in the US written as “low documentation” loans are called ‘sub-prime’ mortgages in the US. These loans are often used by less creditworthy borrowers who are prone to default when circumstances change such as interest rate rise, pushing up mortgage repayments beyond their capacity to pay, or house prices fall substantially making some borrowers less enthusiastic about repaying the loan.

Initially, US home prices continued to rise strongly, boosted by very strong demand.  The consumer maintained their positive outlook. However, as the rate increases continued, demand eased, and home price appreciation slowed. Then came the double whammy of further rate increases as housing values started to decline.

As early as December 2005, mortgage defaults for sub-prime loans had started to increase from earlier levels of around 5%. By mid 2007, the default rate had risen to more than 12%.

Sub-prime mortgages represent 17% of all mortgages in the US compared to 2% in Australia, as shown in the graph below. Problems in this sector have a much bigger impact in the US. Even so, why has a problem in a very narrow segment of the market caused such turmoil?

When risk re-emerged the pain was shared

While the issue has been building for some time, broad market concern has only emerged recently. Markets had become complacent. For an investor, complacency remains a cardinal sin, but it is an ongoing market tendency, matched only by periods when market participants become overly pessimistic.

Complacency in credit markets can be fatal. Unlike shares, loans generally provide no upside. Lenders either get their money back or lose. Many lenders were lulled into a false sense of security by buoyant economic conditions that had reduced defaults for lower quality credit. Risk embedded in some credit, notably sub prime mortgages, had not gone away. When it came to the fore there was pain for those highly exposed.

Many investors did heed the warnings and avoided poorly secured “high yield” investments. Yet they still found themselves exposed to increased volatility. The reason is that financial markets enable risks and returns to be dispersed among many investors. Mortgage loans are no longer fully funded by the lending bank or institution, but rather by capital markets buying various components of the risk. Many mortgage loans make their way into mortgage backed investment pools, which create a number of securities with differing credit risk. In the US, the public issuance of “asset backed” securities nearly quadrupled between 2000 and 2005.

In addition to the securities created, credit markets rapidly grew another group of assets which invested in different issues of mortgage backed securities.

These ‘CDOs’ (Collateralised Debt Obligations) mix debt securities, and typically add leverage to issue various levels of credit rated securities. Further, some CDOs do not invest directly in the debt assets, but rather in derivatives or “Credit Default Swaps”. In addition, hedge funds may take positions in the CDO market and then leverage those positions.

The arrival of these complex products that are highly leveraged has meant the impact of rising defaults with sub-prime mortgages is being felt by many investors. It has not been contained to one segment of the credit market.

The liquidity crisis

What we are seeing now is a repricing of risk. High risk is being priced accordingly. Some players, in particular hedge funds, are having to sell higher quality credit to cover losses incurred with their riskier assets. Funds heavily exposed to sub-prime mortgages, such as the Basis Capital Funds in Australia and Bear Stearns Funds in the US, have suffered significant loses.

There is currently a crisis of confidence in credit markets. Fear that money will not be repaid means that many participants are unwilling to lend. As a consequence, there is a lack of money for borrowers that are very capable of paying it back. Central banks have stepped in to ensure these borrowers, such as high quality companies, have a source of funds.

However the lack of liquidity has made the cost of money higher for businesses that need it.

This higher cost was the reason why RAMS mortgages had to revisit their profit outlook. The impact is being felt across the credit market. It has also impacted the buy out market in equities as private equity funds can no longer secure sufficient borrowings to launch take-over bids for public companies.

In this environment of uncertainty it is not surprising that there has been a spill over into equity markets. Share prices have fallen across the board with the Australian market among the hardest hit, down approximately 10% from its peak in June. This fall is greater than other markets including the US. Finance and Resource stocks have been sold off, and the Australian market that has benefited to date from its large exposure to these sectors is being reminded that the reverse can occur.

Where to from here

The key issue is whether the problems in a small segment of the credit market will have a wider effect on the financial system.  To date there is no evidence that the system has broken down. However those that invested in poor quality credit assets may suffer permanent capital loss.

Those in better quality credit who do not have short term liquidity issues are better placed to ride out this difficult period. Importantly central banks will actively seek to manage liquidity issues. Central banks have pumped billions of dollars into credit markets across the globe to ensure money is available.

Interest rates are higher than they were a few years ago giving central banks scope to reduce rates, either in response to a financial crisis or a traditional cyclical economic downturn. If there was a real break down in the financial system then central banks would cut rates to stimulate borrowing. A similar outcome would occur, but in a more measured fashion, if consumer confidence falls away markedly in the US. While inflation has risen, it is generally believed to be manageable giving central banks the confidence to reduce rates, if necessary, to get the global economy moving

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