Global Trends by Martin Khor
Monday 25 February 2008
The debate goes on whether
There have so many reports
about the recession in the
The median forecast of these
business economists (who work in companies) is that the
If this happens, it would be good news. A couple of quarters of slow growth would actually be a relief, given the recent more gloomy forecasts.
On the other hand, the past week has also brought worrying reports showing that the financial crisis is spreading to other areas.
The crisis began in the “sub-prime”
house mortgage sector in the
Some of the world’s biggest
banks, like Citigroup, Merrill Lynch, UBS, Morgan Stanley and HSBC,
lost many billions of dollars and some had to restore their balance
sheets through massive injections of equity, mainly by sovereign funds
from the Middle-East and
Then the crisis spread to firms in other areas. Two weeks ago came the news that a big company that insures bonds had got into serious trouble. The Financial Guaranty Insurance Company lost its triple-A credit rating, due to guarantees it had made on structured securities, and this raised serious questions about whether it could meet obligations on US$220 billion of municipal bonds that it had also guaranteed.
Last week, the New York Times (NYT) and the Wall Street Journal (WSJ) reported on another potential crisis in the huge market in securities that insure against defaults on companies’ credit, which are known as “credit default swaps.”
The NYT of 17 Feb. explains
how this market works. The swaps are a set of new financial instruments
that are supposed to cover losses to banks and bondholders when companies
default on their debts. The markets for these securities have grown
huge, from US$900 billion in 2000 to over US$45 trillion today, or twice
the size of the
In a credit default insurance, a corporate-bond investor seeks protection (buys insurance) against default of an asset he owns, or a speculator (who is not an owner of the asset) uses the swap to bet on the company’s health. The seller of the insurance is a bank or insurance firm or hedge fund which receives premiums from the insurance buyer and promises to pay him if he defaults on his debt.
But this seller in turn assigns the insurance contract to another party which in turn can assign it to other parties and so on. The problem is that if a default happens, the buyer of the insurance may have difficulties tracking down who now holds the contract and is thus responsible to pay up.
The article concludes that as defaults kick in and events unfold, it will be shown who has managed well and who has not.
The credit-default swap problem
is further explained by the WSJ of 22 February, which said that “the
global financial squeeze is spreading to investments linked to the corporate-debt
market, slamming the value of contracts that provide insurance against
defaults and marking one of the first times that the debt of major companies
has been affected by the turmoil.”
“The indexes' moves could
prove to be self-fulfilling prophecies, causing heavy losses for investors
and making it even harder for people and companies to borrow money.
Adding to the anxiety, analysts can only guess at the volume of investments
tied to the indexes, who is holding them and what it would take to trigger
a full-scale sell-off,” said the WSJ article.
The cost of Euro 10 million
of insurance on the iTraxx index (which tracks the cost of insuring
125 debt issues by European companies) had rose to Euro 123,750 from
Euro 51,320 at the beginning of the year.
”Even in the absence of greater
defaults, the moves in the indexes can cause a great deal of havoc,
triggering a downward spiral in which the forced unraveling of complex
investment products drives ever-larger losses for investors and rises
in the cost of insurance, which in turn could ultimately drive up borrowing
costs for companies all over the world,” said the WSJ article.