PANIC follows mania as night follows day. The credit crunch from the subprime crisis which broke early August has spread at a manic pace, impacting supposedly safer markets and asset classes.
Financial market conditions have deteriorated in the United States and have the potential to restrain economic growth moving forward. Greed and fear, it seems, are once again engaged in battle; a battle as old as financial markets itself.
In an unprecedented move, the Fed cut its discount rate by 0.5 percentage point to 5.75% in response to the credit turmoil, giving markets a brief respite.
Money managers however staged a dramatic flight to safety, knocking down yields on short-term US government debt by as much as 160 basis points on the one-month treasury.
The scramble to obtain government paper at any price is a sign of extreme risk aversion, and suggests the Fed’s actions have yet to stabilise sentiment in credit markets. The next four to six weeks will be crucial as investors try to establish new price levels for risk and banks expand their balance sheets to take on assets held by stricken investment vehicles.
The market is expected to get much worse before it begins to get better.
For one, subprime problems will take time to surface because of information gaps – there is no agreement on how much money has vanished; no one really knows where they reside, when they will surface, or whether they have surfaced at all.
Compounding this is mortgage resets. The peak in US mortgage resets (when the mortgage rate moves from fixed to floating) is in October, and will continue for about a year. As such, defaults and further de-ratings of subprime mortgages will continue to accumulate.
This is expected to impact US$10bil – US$20bil worth of mortgages, further creating pressure on the already anaemic credit market – delinquent home loans are already piling up as fast as the inventory of unsold homes.
What is more compelling however is that some pension funds and insurance companies argue that accounting rules in the US allow them to mark subprime derivatives at cost or mark to model.
In this instance, default exposures will tend to remain dormant, perpetuating further credit weakness.
A nervous capital market in an already morose US economy depicts further economic malaise moving forward. US consumer spending is slowing, capital expenditure is hardly robust and exports do not account for a large enough proportion of the economy to take up the slack.
The silver lining is that the Fed had cut rates twice thus far (by 50bps on Sept 18 and 25bps on Oct 31) to boost economic growth – but the game is far from over.
A cut in US interest rates at this juncture will only be effective if the current problem is a temporary lack of liquidity, not a credit crisis.
Interest rate policies remain guided by the broad outlook of the economy and the objective of achieving full employment and price stability.
The crux of this crisis is whether the availability of credit has dried up to the non-bank financial sector as a result of the pull back in credit markets.
The tools that modern central banks possess to address liquidity problems can only directly address such runs inside the traditional banking sector, and do not directly reach the non-bank financial sector, which appears to have been hardest hit by the current credit crunch.
By contrast, the impact on Asian financial markets has not been too severe.
Although post-Asian crisis recovery remains work-in-progress, the region as a whole is resilient.
Credit conditions have not tightened and yields on Asian and sovereign papers have only risen marginally. Modest outflows from capital markets and low sovereign risk downgrades further underscore Asia’s sound macro fundamentals.
Reserves, for one, at a whopping US$4 trillion allows central banks the flexibility to weather any potential systemic liquidity disruptions.
Also, unlike the US where the majority of bank funding originates from the credit markets, Asian banks have traditionally relied on their more stable retail deposit base. Nevertheless, the risk of contagion cannot be downplayed, and markets will be apt to manage risk more proportionately.
Today’s credit crisis is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The knock-on effects from a global confidence crisis and risk aversion remain a clear and present threat to global markets.