World stock markets have been on a roller-coaster ride in recent weeks. Defaults in the U.S. subprime mortgage market have rippled through the global economy, forcing central banks to inject liquidity into their banking systems as credit tightened. The jitters are another reminder of the interconnectedness of financial markets. Central bankers must keep a close eye on international developments and new financial instruments that create and amplify the connections between markets.
The recent shock waves began in the United States, when a growing number of Americans with subprime mortgage loans fell behind on their payments. Despite poor credit ratings, they had managed, courtesy of banks with excess capital and eager to find new markets, to get loans to buy homes. Other credit institutions wanting in on the action created securities backed by these loan portfolios. Low interest rates encouraged financial institutions to take out loans to buy the higher-risk (and higher-return) securities. Then, since this spring, as debtors predictably defaulted, a number of the original subprime lenders have reported liquidity problems that have spread to the holders of the debt-backed securities, both in the U.S. and overseas.
In recent weeks, the markets have realized that financial institutions once considered stodgy and conservative had embraced innovative investment vehicles that left them very exposed when the original loan holders could not pay up. Last month, Bear Stearns, a large U.S. investment house, was forced to close two hedge funds that lost more than $20 billion on mortgage-backed investments.
Last week’s slide in the markets was triggered by revelations that the largest French bank BNP Paribas had to freeze billions of dollars in assets in mutual funds linked to those mortgages. Deutsche Postbank, Germany’s biggest retail bank, revealed it had 600 million euros ($822 million) in exposure to two investment vehicles run by another German bank. Goldman Sachs provided billions of dollars for its own hedge funds that were also dangerously illiquid.
Central bankers quickly responded with an unprecedented injection of capital into markets around the world. The European Central Bank led the way, adding $130 billion on Thursday of last week and another $83 billion Friday. The U.S. Federal Reserve Bank provided $24 billion and $38 billion, respectively, on those two days. The Bank of Japan added $8.4 billion last Friday while the Reserve Bank of Australia provided nearly $5 billion. On Monday, the ECB added another $64.9 billion, the Bank of Japan $5.1 billion more, and the Fed just $2 billion. Further capital injections by central banks followed.
After some gut-wrenching drops — the Dow fell 387 points last Thursday, the second worst performance of the year, while the Nikkei was down more than 2 percent, the London exchange fell more than 3 percent, along with other major European markets, and South Korea’s Kospi dropped 4.27 percent, the biggest decline since June 2004 — the markets still seem to be unstable.
Long-term, there are reasons for concern. Apart from continuing exposure among financial institutions, there are worries that U.S. housing prices may finally be headed for readjustment. Economists have warned that credit has been too loose and the result has been asset bubbles, particularly in U.S. real estate. With considerable amounts of consumer net worth tied up in home valuations, a downward adjustment would leave Americans with considerably less money to spend.
In a troubling sign of weakness, in July, 61 percent of retailers missed sales growth expectations for stores open at least a year, compared to the norm of 42 percent. That trend will be magnified by the fall in value of mutual funds and other investment vehicles tied to real estate. Thus, even though Asia is awash in cash — gross capital inflows into East Asia reached $269 billion last year — it could suffer as Americans spend less on imported goods that originate in this part of the world.
The real concern is that banks and other financial institutions will become increasingly illiquid as their own investments and holdings decrease in value. They will be forced to hoard funds, thus making it more difficult for other borrowers to get capital. That process appears to be under way. One estimate is that in two months, 46 corporate loans worth $60 billion have been postponed or reduced in size.
Fundamental structural weaknesses remain. Global financial markets are so increasingly interlinked with new technologies that information and vulnerabilities are transmitted instantaneously. In increasingly diversified financial institutions, operations in one division can spill over into others. We can only hope that the tools of financial surveillance are as powerful as those generating new wealth.
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