No insulation from subprime crisis

ARAB stocks have emerged virtually unscathed from a global meltdown caused by a malignancy devouring US subprime credit market.

Following the rout in US and European stock markets, Asian stocks tanked to their lowest in 17 years last week.
Equities in the Middle East resisted the global market decline, perhaps helped by the very low level of Western institutional ownership in the region.
However, this trend need not sustain for long, given the fundamental nature of stock markets to turn volatile, swiftly absorbing ripples elsewhere.
It doesn’t take much for the jittery bourses in the region to react sharply keeping in mind that they have still not recovered fully after the historic crash in 2005.
No doubt the US Federal Reserve came to the stock market’s rescue on Friday last but unless credit markets remain stable this week, the stock markets would revert to their nosedive mode.
Fed chairman Ben Bernanke had said in congressional testimony last month that financial institutions may shoulder $50 billion to $100 billion in losses due to defaults on subprime mortgages.
In the case of the savings-and-loan crisis in the US in the latter half of the 1980s, costs associated with Resolution Trust Corp’s takeover of financial institutions and bad loans reached two per cent of nominal gross domestic product (GDP).
Should the losses related to subprime loans be at a level predicted by the Fed chairman, they would amount to less than one per cent of US GDP, leading many market players to believe that the impact on US financial institutions will be limited.
Despite these figures, instability in the stock market continues partly due to unease that new losses will come to light. Some 80 per cent of the balance of subprime loans have been securitised, such as into residential mortgage-backed securities.
Because these have been repackaged and sold to various investors, it is difficult to see who will suffer losses, and this is making stock prices fluctuate wildly.
But is the current crisis just about some mortgage defaulters in the US and a few financial institutions suffering bad debts because of that?
It is already clear that the mess is about more than that. Hedge funds and private-equity firms are nursing big losses. Debt markets that once disbursed cash to all are tight or closed altogether. In almost every asset market, investors are scampering to reprice risk.
The gravest and most immediate threat is to the banking system. For the time being, banks no longer trust other banks enough to lend them money except on onerous terms.
Equally worryingly, they lack confidence that other banks will trust them if they want to borrow. It is of concern that the very institutions that exist to supply the economy with credit start to hoard it from each other.
The positive is that this tightens monetary policy. On the negative side, a shortage of cash will cripple the payments system and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.
Experts fear that the rising defaults in US subprime mortgages could result in an economic slowdown in the United States and a global credit crunch, and nervous investors have picked up on the anxiety, whether it’s justified or not.
The complex nature in which subprime loans are securitised and sold obscures who will shoulder the bulk of the losses.
To deal with the spreading subprime-loan jitters, central banks in Japan, the US and Europe have pumped large amounts of funds into money markets since the latter half of last week in an attempt to prevent a crisis in which financial institutions lack the necessary funds for settlements.
The moves were seen not just as an attempt to alleviate credit concerns and prevent a sharp rise in market interest rates but as a clear indication from the banks that they will do everything in their power to prevent a panic.
The central banks will recover the funds they injected when market instability recedes or when open-market operations expire.
Investors are worried about a global credit crunch as more banks and investment funds around the world reveal their exposure to the slumping US subprime, or high-risk, home loan sector, analysts said.
The fear is that banks will suspend normal lending practices as they move to cover their losses, thereby restricting access to credit for investors and companies.
It’s not clear how long the subprime turmoil will continue so financial shares will be sold until this problem is solved completely. What scares people with the global liquidity crunch in credit markets is that if companies can’t raise money to expand, then there’s a flow-on effect for the economy.
Investors borrow funds in countries with low interest rates such as Japan to fund purchases of higher-yielding assets abroad, a practice referred to as the carry trade.
Volatility in the market increases the risk of those bets and has been a primary reason for investors to pay back their yen loans, boosting the currency’s value.
As the market turmoil continues, GCC countries, including the UAE, which is introducing newer financial concepts by the day, could take steps to ensure that they did not indulge in indiscriminate mortgage lending to support their real estate sector.
Considered the banking hub of the region with a number of offshore banks, Bahrain faces a twin dilemma – what model of securitisation would it accept so that banks do not get hurt and how would it compete effectively in the real estate sector if mortgage lending rules are tightened.

Talking Business
K S Sreekumar
sreekumar@tradearabia.net