The problem with the U.S. subprime mortgage market — housing loans made to high-risk borrowers — had a global impact on markets this month, forcing monetary authorities in Japan, the United States and Europe to pump huge amounts of liquidity into money markets to prevent a credit crunch.
The U.S. Federal Reserve also felt compelled to cut the discount rate 0.5 percent in a special meeting on Aug. 17.
Let’s take a look at how this became a global problem and what is at the bottom of the process.
Even if housing loans go sour in the United States, the damage should be limited to U.S. financial institutions if the stakes are restricted to nonperforming loans held by the banks. This means the impact would normally be contained within the country.
But the reason it has caused international repercussions is because some of the loans were sold on the open market as mortgaged financial products and bought in huge volumes by hedge funds and other investors seeking products with higher returns.
That’s why reports about troubled hedge funds linked to U.S. brokerages and a fund freeze by a major French bank spread so much anxiety to global markets so quickly.
Hedging is the act of offsetting the risk or potential risk inherent in economic activity through multiple means. There are many more ways to hedge than engaging in routine risk-covering.
For example, a Japanese exporter operating in dollar-denominated contracts will try to avoid the risk of the dollar depreciating against the yen by reserving the right to sell U.S. dollar futures. This is an act of covering. The move fully eliminates price risk, although the exporter’s trading partner remains exposed.
However, an exporter to China working with yuan-denominated contracts won’t be able to do the same thing because Chinese monetary authorities do not allow liberalized yuan futures markets.
Therefore, the exporter will try to deal indirectly with yuan exchange rate fluctuations by selling currencies forecast to move in the same direction as the yuan — like the Hong Kong dollar. This type of indirect risk management technique is called a hedge. People concerned about a decline in buying power often hedge against inflation by investing in gold.
Now hedge funds manage their assets in multiple ways, but one reason they’re called hedge funds is because that is exactly what they are supposed to do — hedge.
This is usually performed by combining purchases of shares deemed undervalued with sales of shares deemed overvalued. But this is guided by the judgment of each fund manager, and sometimes the price of undervalued shares falls further while those that were overvalued rise higher. In times like this, hedge fund managers often fail and end up incurring dual risks.
Given what is happening today, it appears the term “hedge fund” is a misleading one. If these funds can’t guarantee that their risks are being properly hedged, they should use a different name that better reflects the nature of what they are.
Since investors in hedge funds can legally be limited to small numbers, financial authorities might be tempted to disregard the problem, saying wealthy people should know what they’re doing. But there are two reasons why this logic doesn’t work.
First, there are concerns that investment trusts, which serve large numbers of ordinary investors, are having the same problem.
Second, when hedge funds move to sell the shares they hold to cover losses, they have a negative impact on the market. Stock prices nosedived worldwide on Aug. 9 when concern spread about the U.S. subprime mortgage crisis.
The stock market turbulence also spread to the currency markets as hedge funds sold stocks denominated in local currencies and bought back the original investment currencies. This caused the yen to rise and European currencies to fall.
The biggest problem with all these different types of uncertainties — share prices, credit markets and foreign exchange rates — is the impact they are having on the real economy. This is what is believed to have prompted the central banks to inject all that liquidity into the market.
The act in itself, however, is contradictory because the global economy is also facing inflationary pressure from other factors, such as high oil prices.
The monetary policies of the Bank of Japan and the U.S. Federal Reserve are at a difficult juncture now because an interest rate cut by the Fed or a rate hike by the BOJ might increase volatility in the currency markets even further.
But it must be noted again that the sharp rise in the number of hedge funds is a sign of excessive liquidity worldwide, and the huge growth in yen-carry trades has come to symbolize this.
Japan has been a major source of this excess liquidity, and the BOJ needs to pursue its monetary policies based on that recognition.
Teruhiko Mano is a professor at Seigakuin University Graduate School.