TWN Info Service on Finance and Development (Mar08/01)

3 March 2008

CREDIT CRISIS RAPIDLY SPREADING TO NEW AREAS

Just when there were so many reports about the recession in the United States, there was the news last Saturday that only 45% of business economists (who work in companies and financial institutions) in the US believed that a recession would take place this year. And the majority of those predicting recession thought it would be brief, while only a small minority thought there would be a deep and protracted recession.

But there is a good chance that this overall forecast will prove too optimistic. The “real economy” of production and employment is more likely to be adversely affected by the grave weaknesses being revealed in the financial sector. The past few weeks have brought worrying reports showing that the financial crisis is spreading to other areas.  The evidence is mounting that there may be a much greater unravelling of the financial system than earlier anticipated.

Below is an analysis of the current credit crisis which has implications for the “real economy” of production and employment. It published in the SUNS #6426 Monday, 3 March 2008.

With best wishes
Martin Khor
TWN

Credit Crisis Rapidly Spreading to New Areas

By Martin Khor, Geneva, 29 February 2008

Just when there were so many reports about the recession in the United States, there was the news last Saturday that only 45% of business economists (who work in companies and financial institutions) in the US believed that a recession would take place this year.

And the majority of those predicting recession thought it would be brief, while only a small minority thought there would be a deep and protracted recession.

The median forecast of these business economists (who work in companies) is that the US would have slow economic growth of 0.4% in the first quarter, which would then pick up to 1% in the second quarter and 2.8% in the third and fourth quarters of this year.

But there is a good chance that this overall forecast will prove too optimistic. The “real economy” of production and employment is more likely to be adversely affected by the grave weaknesses being revealed in the financial sector.

The past few weeks have brought worrying reports showing that the financial crisis is spreading to other areas.  The evidence is mounting that there may be a much greater unravelling of the financial system than earlier anticipated.

The crisis began in the “sub-prime” house mortgage sector in the US. It then spread to many banks in the US and Europe which had invested in financial instruments linked to the value of these sub-prime mortgages. 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 Asia.

Then the crisis spread to firms in other areas. Three weeks ago came the news that a big company that insures bonds had got into serious trouble. The Financial Guaranty Insurance Company (FGIC) 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.

Regulators in New York have been trying to prevent a municipal bond crisis that would increase the funding costs for municipal borrowers in the US. Many banks that bought insurance from FGIC on mortgage-backed securities and collateralized debt obligations are likely to take on losses.

Last week, the New York Times 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 New York Times of 17 February explains how this market works. The swaps are another set of new financial instruments that are supposed to cover losses to banks and bondholders when companies default on their debts.  According to the New York Times, 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 US stock market.

In credit default insurance, a company-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, a bank or insurance firm or hedge fund, receives premiums from the insurance buyer and promises to pay the insurance-buyer 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 market value of the contracts (US$45 trillion) is much more than the US$5.7 trillion corporate bonds whose defaults the swaps were created to protect against. 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.”

It added that investors in credit-default swaps have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes have doubled since the start of the year, meaning that investors who sold this insurance suffered losses.

“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 article.

As of 21 February, the annual cost of five years of insurance against default on US$10 million in bonds on the CDX index (which tracks North America companies) had risen to US$152,000 from US$80,970 at the start of the year.

The cost of €10 million of insurance on the iTraxx index (which tracks the cost of insuring 125 debt issues by €pean companies) had rose to €123,750 from € 51,320 at the beginning of the year.

A rise in the cost of insurance means a loss for investors who sold insurance, because the only way to get out of these investments is to buy another insurance policy to replace the policy they sold in the first place.

For example, if the cost of five-year insurance on the CDX rose to US$100,000 a year, an investor who had sold the insurance for US$50,000 a year would have to pay an added US$50,000 for five years to get out of the contract – a loss with a present value of about US$200,000.

“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 unravelling 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.

Hedge funds are another set of institutions that are facing problems. The Wall Street Journal in an on-line article on 23 February gave examples of several hedge funds that have suffered losses, with many also seeing their investors pulling out their money.

The total assets managed by the funds have jumped from US$490 billion in 2000 to US$1.9 trillion at present. Last month alone, so-called “quantitative” hedge funds fell 6% as a group.

Among the hedge funds that hit a bad patch are:

-- Fortress Investment Group LLC, whose shares are down 50% in the past year.

-- A pair of US$2 billion funds run by AQR Capital Management Inc. are down about 15% this year.

-- Citigroup just announced a bailout of an in-house hedge-fund group affected in part by bad bets on highly complex mortgage-related securities.

-- D.B. Zwirn & Co. and Sailfish LLC have both seen investors rush for the exits, forcing each firm to close big funds.

-- In recent weeks at Zwirn, clients have moved to withdraw some US$2 billion from the firm’s US$5 billion in assets. Zwirn will sell US$4 billion of investments over the next few years from its two largest hedge funds.

These are only some examples of the spread of the crisis. More examples in other areas are being reported on an almost weekly or even daily basis. The bottom of the finance crisis is nowhere in sight yet, and it will certainly have a serious negative effect on the real economy of growth and jobs.