Themes > Current Issues
05.09.2007
Can the US Fed help Asian Markets?
C.P. Chandrasekhar
Governments
and regulators have stood by and watched as shares have taken a battering
in Asian markets in recent weeks. In many of these countries, including
India, growth has been and remains creditable and corporate profits have
been soaring. The market downturn everybody agrees is not the result of
poor fundamentals in these countries but of developments in the US, especially
its subprime housing market where defaults and foreclosures have been
on the rise. Institutions reeling under the knock-on effects of that crisis
are selling out in Asian markets to find the money to rebalance their
capital structures or meet their commitments. Such behaviour is easily
explained. Institutions overexposed to complex structured products whose
valuation is difficult are saddled with relatively illiquid assets. If
any development leads to liquidity problems they are forced to sell-off
their most liquid assets such as shares bought in booming emerging markets.
A quick return to stability in those markets therefore is dependent on
developments elsewhere.
Not surprisingly, the decision of the US Fed to intervene and attempt to resolve the crisis has been received with much relief. But thus far the Fed's moves have been limited to marginally improving the flow of credit to ease the liquidity crunch that is seen as worsening the ripple effects of the subprime crisis. The Fed has reduced its discount rate, at which banks can borrow from the central bank against collateral of various kinds, including the now dreaded subprime mortgages, and also extended the period for which such loans were available from one to 30 days. The discount rate has been reduced by 50 basis points from 6.25 to 5.75 per cent—a move that is seen as a precursor to a reduction in the benchmark rate that would reduce the cost of credit.
The decision to introduce changes in the discount window is motivated by the perception that a freeze of credit flow through the financial system is the way in which the subprime crisis impacts on other segments of market. This occurs because of the complex web that liberalized and globalized finance weaves, starting from rather simple assets like housing mortgages. Canvassed by brokers these mortgages are financed by mortgage lenders such as Countrywide Financial. These lenders then sell some or all of these mortgages to the banks, especially Wall Street Banks like Bear Stearns and Lehman Brothers. Those banks bundle mortgages of different degrees of default risk to create securities consisting of tranches that are differentially rated by rating agencies, depending on the protection from risk they enjoy. These tranches are bought into by pension funds, insurance companies, investment funds and hedge funds depending on their appetite for risks and returns. And some of these entities, especially highly leveraged institutions like the hedge funds, finance their investments in these mortgage-backed securities by borrowing from the banks themselves.
The threads that provide the warp and weft in this complex weave are credit obligations of various kinds. Institutions such as mortgage lenders and hedge funds need credit to keep their businesses going. But credit is difficult to come by when market sentiment is bleak. And it is precisely then that the demand for credit rises. Depending on the contract, lenders can periodically call back their credit or demand larger margin deposits as the value of the collateral associated with that credit is perceived to fall. Investors in funds buying into mortgage backed securities too want to cut their losses and demand redemption of their investments. This is what happens when the market is looking down, worsening the impact of the crisis. Easier credit, the Fed therefore believes, will lubricate the market and restor activity.
On the other hand, easy credit is what created the problem in the first place. When liquidity is easy and interest rates low, the volume of transactions financed with credit tend to multiply. But for this to happen the base assets—in this case housing mortgages—must burgeon as well. Increasing the volume of mortgages to cater to the supply-side push created by excess liquidity, inevitably requires moving into segments of the market that involving lending to ''subprime'' borrowers or those with scores for creditworthiness much lower than prime borrowers..
This was achieved by relaxing income certification requirements for borrowers. It was also ensured by sweetening loans with structured interest obligations, starting with an attractive initial low interest rate and moving on to much higher rates when the loans are reset. So long as subprime mortgages remained a small proportion of the total the risk involved was low. But problems arise when either designated sub-prime loans increase in share relative to the total or when some designated as prime borrowers turn out to be sub-prime.
Both of these have happened in the US in recent months, assisted by the layered and hierarchical structure of the financing of mortgages described above. An expected consequence of that structure is the dispersion of risk across the financial system. This is partly true. Each set of players—the mortgage brokers earning a fee, the mortgage finance companies financing the mortgage but expecting to be financed in turn by Wall Street banks, the banks that hope to create securities that can be sold as investments and the investors who expect their investment to be financed with credit—bears a small part of the risk, if any at all. But risk dispersion does not necessarily make the system safe. Rather, it reduces the extent of diligence exercised by each player when choosing to lend or invest. And rating agencies do not correct for this, since they are paid fat fees for delivering ratings based on inadequate information that are often revised when it is too late. The net result is risk builds up with no response from agents in an increasingly self-regulated financial system and little action from regulators who often are not even aware of the magnitude of the problem.
The structure gives when mortgage defaults begin and multiply and rising foreclosure reduces the value of the housing collateral. That collateral also turns illiquid because of a lack of buyers, since rising default risk leads to a curtailment of mortgage lending and housing demand. The first to get hit are the mortgage lenders, who find that the assets they created are suffering losses. Even if they do not carry the burden of those losses in full, they find that financing to carry on their business from conventional sources dries up. This is what happened to Countrywide Financial , the largest mortgage lender in the US, forcing it to opt to use a $11.5 billion back-stop line of credit it has with a group of 40 banks.
This liquidity crunch, which Countrywide may temporarily overcome because of its special circumstances, moves up the chain. The other set of agents severely affected are the investors in funds that have bought into mortgage-backed securities, including funds set up by Wall Street banks such as Bear Stearns. As mortgage lenders find themselves saddled with losses and out of business, investors exposed to mortgage-backed securities begin worrying about the value of their investments. Rating agencies, keen to save their reputation, belatedly downgrade these instruments, encouraging investors to redeem their investments as soon as they can. Redemption demands increase requiring the funds to either borrow or sell other assets to meet redemption claims or, in the extreme case as happened with bear Stearns to freeze redemptions. The problem here is that the mortgage-backed securities themselves can either be sold only at a substantial loss or cannot be sold at all, since potential buyers have no way of confirming what their true value is. They become worthless paper. Borrowing to meet redemption claims would therefore be the better option, but credit is not easy to come by since banks are either not willing to lend or are cash-strapped because funds they have set up or have lent too are also folding down.
On the surface the Wall Street banks themselves appear relatively less vulnerable to the default at the base of the structure, because they had transferred the risk implicit in their exposure by creating mortgaged-backed securities and selling them to other investors such as the hedge funds. But institutions created by the banks themselves, linked to them in today's more universalized banking system or leveraged with bank finance often buy these instruments created to transfer risk. In the event, as The Economist (August 11th, 2007) recently put it, ''banks (that) have shown risk out of the front door by selling loans, only .. let it return through the back door.'' This it notes is what exactly transpires in the relationship between the three major prime broking firms—Goldman Sachs, Morgan Stanley and Bear Sterns—that offer prime broking services, including loans, to highly leveraged institutions like hedge funds.
Banks are depository institutions and therefore have the ability to create credit. But hit by the ripple effects of crises in other market segments, they too turn wary and choose to hold onto their balances rather than lend in times of uncertainty. The net result is a liquidity crunch in the market that has two effects. First, many institutions that base their businesses substantially on borrowed capital such as the mortgage lenders, the hedge funds and private equity firms are forced to downsize their operations with attendant effects on their balance sheets or their investments. Inasmuch as their operations are crucial to sustain activity in housing and stock markets (for example), the knock on effects of the subprime crisis is felt in those markets as well, resulting in a housing price or stock market collapse.
Unfortunately this is precisely what has been happening in most emerging markets including those in Asia, which have been driven in recent months by foreign investments in their stock markets, principally by the hedge funds. When liquidity problems arise, even for reasons unrelated to these markets themselves or the countries in which they are located, these investments are quickly unwound precisely because those markets are still liquid and a collapse of the kind seen since end-July ensues. It hardly bears stating that a collapse that is in the form of a mere ''correction'' can soon turn into a full-fledged crisis.
Can the Fed through its actions help stabilize these markets? Not if its moves are merely meant to improve liquidity. Banks don't lend any more not just because they are strapped for cash but because they are afraid of increasing their indirect exposure to the housing market. If that has to change that market has to revive, requiring a restructuring of debt. Ensuring that will require bailing out financial firms by using tax payers' money as happened with the Savings and Loan crisis. The Fed alone cannot ensure that. The President and Congress must join hands with it. And American tax payers must be willing to comply.
Not surprisingly, the decision of the US Fed to intervene and attempt to resolve the crisis has been received with much relief. But thus far the Fed's moves have been limited to marginally improving the flow of credit to ease the liquidity crunch that is seen as worsening the ripple effects of the subprime crisis. The Fed has reduced its discount rate, at which banks can borrow from the central bank against collateral of various kinds, including the now dreaded subprime mortgages, and also extended the period for which such loans were available from one to 30 days. The discount rate has been reduced by 50 basis points from 6.25 to 5.75 per cent—a move that is seen as a precursor to a reduction in the benchmark rate that would reduce the cost of credit.
The decision to introduce changes in the discount window is motivated by the perception that a freeze of credit flow through the financial system is the way in which the subprime crisis impacts on other segments of market. This occurs because of the complex web that liberalized and globalized finance weaves, starting from rather simple assets like housing mortgages. Canvassed by brokers these mortgages are financed by mortgage lenders such as Countrywide Financial. These lenders then sell some or all of these mortgages to the banks, especially Wall Street Banks like Bear Stearns and Lehman Brothers. Those banks bundle mortgages of different degrees of default risk to create securities consisting of tranches that are differentially rated by rating agencies, depending on the protection from risk they enjoy. These tranches are bought into by pension funds, insurance companies, investment funds and hedge funds depending on their appetite for risks and returns. And some of these entities, especially highly leveraged institutions like the hedge funds, finance their investments in these mortgage-backed securities by borrowing from the banks themselves.
The threads that provide the warp and weft in this complex weave are credit obligations of various kinds. Institutions such as mortgage lenders and hedge funds need credit to keep their businesses going. But credit is difficult to come by when market sentiment is bleak. And it is precisely then that the demand for credit rises. Depending on the contract, lenders can periodically call back their credit or demand larger margin deposits as the value of the collateral associated with that credit is perceived to fall. Investors in funds buying into mortgage backed securities too want to cut their losses and demand redemption of their investments. This is what happens when the market is looking down, worsening the impact of the crisis. Easier credit, the Fed therefore believes, will lubricate the market and restor activity.
On the other hand, easy credit is what created the problem in the first place. When liquidity is easy and interest rates low, the volume of transactions financed with credit tend to multiply. But for this to happen the base assets—in this case housing mortgages—must burgeon as well. Increasing the volume of mortgages to cater to the supply-side push created by excess liquidity, inevitably requires moving into segments of the market that involving lending to ''subprime'' borrowers or those with scores for creditworthiness much lower than prime borrowers..
This was achieved by relaxing income certification requirements for borrowers. It was also ensured by sweetening loans with structured interest obligations, starting with an attractive initial low interest rate and moving on to much higher rates when the loans are reset. So long as subprime mortgages remained a small proportion of the total the risk involved was low. But problems arise when either designated sub-prime loans increase in share relative to the total or when some designated as prime borrowers turn out to be sub-prime.
Both of these have happened in the US in recent months, assisted by the layered and hierarchical structure of the financing of mortgages described above. An expected consequence of that structure is the dispersion of risk across the financial system. This is partly true. Each set of players—the mortgage brokers earning a fee, the mortgage finance companies financing the mortgage but expecting to be financed in turn by Wall Street banks, the banks that hope to create securities that can be sold as investments and the investors who expect their investment to be financed with credit—bears a small part of the risk, if any at all. But risk dispersion does not necessarily make the system safe. Rather, it reduces the extent of diligence exercised by each player when choosing to lend or invest. And rating agencies do not correct for this, since they are paid fat fees for delivering ratings based on inadequate information that are often revised when it is too late. The net result is risk builds up with no response from agents in an increasingly self-regulated financial system and little action from regulators who often are not even aware of the magnitude of the problem.
The structure gives when mortgage defaults begin and multiply and rising foreclosure reduces the value of the housing collateral. That collateral also turns illiquid because of a lack of buyers, since rising default risk leads to a curtailment of mortgage lending and housing demand. The first to get hit are the mortgage lenders, who find that the assets they created are suffering losses. Even if they do not carry the burden of those losses in full, they find that financing to carry on their business from conventional sources dries up. This is what happened to Countrywide Financial , the largest mortgage lender in the US, forcing it to opt to use a $11.5 billion back-stop line of credit it has with a group of 40 banks.
This liquidity crunch, which Countrywide may temporarily overcome because of its special circumstances, moves up the chain. The other set of agents severely affected are the investors in funds that have bought into mortgage-backed securities, including funds set up by Wall Street banks such as Bear Stearns. As mortgage lenders find themselves saddled with losses and out of business, investors exposed to mortgage-backed securities begin worrying about the value of their investments. Rating agencies, keen to save their reputation, belatedly downgrade these instruments, encouraging investors to redeem their investments as soon as they can. Redemption demands increase requiring the funds to either borrow or sell other assets to meet redemption claims or, in the extreme case as happened with bear Stearns to freeze redemptions. The problem here is that the mortgage-backed securities themselves can either be sold only at a substantial loss or cannot be sold at all, since potential buyers have no way of confirming what their true value is. They become worthless paper. Borrowing to meet redemption claims would therefore be the better option, but credit is not easy to come by since banks are either not willing to lend or are cash-strapped because funds they have set up or have lent too are also folding down.
On the surface the Wall Street banks themselves appear relatively less vulnerable to the default at the base of the structure, because they had transferred the risk implicit in their exposure by creating mortgaged-backed securities and selling them to other investors such as the hedge funds. But institutions created by the banks themselves, linked to them in today's more universalized banking system or leveraged with bank finance often buy these instruments created to transfer risk. In the event, as The Economist (August 11th, 2007) recently put it, ''banks (that) have shown risk out of the front door by selling loans, only .. let it return through the back door.'' This it notes is what exactly transpires in the relationship between the three major prime broking firms—Goldman Sachs, Morgan Stanley and Bear Sterns—that offer prime broking services, including loans, to highly leveraged institutions like hedge funds.
Banks are depository institutions and therefore have the ability to create credit. But hit by the ripple effects of crises in other market segments, they too turn wary and choose to hold onto their balances rather than lend in times of uncertainty. The net result is a liquidity crunch in the market that has two effects. First, many institutions that base their businesses substantially on borrowed capital such as the mortgage lenders, the hedge funds and private equity firms are forced to downsize their operations with attendant effects on their balance sheets or their investments. Inasmuch as their operations are crucial to sustain activity in housing and stock markets (for example), the knock on effects of the subprime crisis is felt in those markets as well, resulting in a housing price or stock market collapse.
Unfortunately this is precisely what has been happening in most emerging markets including those in Asia, which have been driven in recent months by foreign investments in their stock markets, principally by the hedge funds. When liquidity problems arise, even for reasons unrelated to these markets themselves or the countries in which they are located, these investments are quickly unwound precisely because those markets are still liquid and a collapse of the kind seen since end-July ensues. It hardly bears stating that a collapse that is in the form of a mere ''correction'' can soon turn into a full-fledged crisis.
Can the Fed through its actions help stabilize these markets? Not if its moves are merely meant to improve liquidity. Banks don't lend any more not just because they are strapped for cash but because they are afraid of increasing their indirect exposure to the housing market. If that has to change that market has to revive, requiring a restructuring of debt. Ensuring that will require bailing out financial firms by using tax payers' money as happened with the Savings and Loan crisis. The Fed alone cannot ensure that. The President and Congress must join hands with it. And American tax payers must be willing to comply.
© MACROSCAN 2007