September-October 2007

The fallout from the imploding US housing sector spread during August and September, as more lenders and hedge funds, including European ones, became victims of their involvement with subprime mortgage debt.

The fallout from the imploding US housing sector spread during August and September, as more lenders and hedge funds, including European ones, became victims of their involvement with subprime mortgage debt. The subsequent re-pricing of risk saw the global money market almost dry up at one point, causing some investors to sell assets at fire-sale prices and obliging major central banks to pump liquidity into the money market, on a scale last seen in the immediate aftermath of 9-11, and adjust monetary policy in an attempt to soothe the market’s nerves.

To recapitulate on the background to this development, the US housing boom, which began in 2001 and was itself a by-product of the low interest-rate environment prevailing after 9-11, encouraged mortgage lenders into widening their activities. Scrambling to meet the surge in mortgage demand, many lenders dispensed with the “due diligence” process of assessing borrowers’ creditworthiness. Parallel with this, investment banks developed an appetite for packaged debt, bundling the mortgages into securities and selling these on to hedge funds and asset managers, many of whom leveraged their assets to finance the purchases. The subsequent rise in mortgage delinquencies at the lowest (subprime) level undermined the perceived value of some of these securities, which then created uncertainty about the true value of all credit-related debt, especially the more sophisticated issues, thus precipitating the current malaise.

The burgeoning credit crunch has also upset equities. Before the recent setback, much of the markets’ advance this year had been due to M&A activity. Rising risk aversion has raised the price of credit and this is likely to undermine not only potential deals but also existing ones that have been largely financed with debt. At the very least, this has flattened the M&A premium hitherto prevailing. There have also been financing concerns, and even companies that enjoy superior credit ratings have had trouble selling their commercial paper (short-term debt instruments, typically issued to finance items such as near-term liabilities, accounts receivable etc.). Despite central bank initiatives, short-term borrowing costs remain higher than before and, for many companies, this will inevitably take its toll on profitability, as well as impacting future capital spending.

It remains unclear how deep the collapse of the subprime market will run in the final analysis, as no comprehensive data are available that might indicate the possible extent of the damage. Estimates vary at anything between $100 billion and $200 billion, but disclosure in this particular instance is a matter for individual financial institutions, not regulators, and there may therefore be worse to come. However, it is worth noting that the US economy has weathered worse crises, notably the Savings and Loan debacle of the early 1990s, which cost an estimated $153 billion, or around 2.5% of US GDP at the time (this is of an altogether higher magnitude than the present problem, since $200 billion today is roughly 1.5% of US GDP).

Investors should bear in mind that the subprime implosion was the result of excessive risk-taking, which created an imbalance that has now begun to resolve itself. It could easily have happened at a worse point in the business cycle, and there is a therefore a good chance that the global economy, in its current condition, is resilient enough to absorb the de-leveraging now taking place.