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By EVAN DAVIS
What is behind the market turmoil?
IT’S taken for granted in most of the
coverage of the current market troubles that sub-prime problems
in the US mortgage market are causing declines in world share
prices.
But why are they having such a widespread effect?
The best guess is that there are a potential US$100 billion
worth of sub-prime mortgage defaults, from less than
credit-worthy borrowers, mainly in the United States.
So why was US$120 billion wiped off shares in London alone last
Thursday?
The reason must be that there are deeper links between sub-prime
lending and equities.
Banking sector losses
First, there are some sub-prime losses among banks (or the
people to whom they’ve lent), and banks are listed on the stock
markets. So banks may be worth less than we thought last year.
And it only adds to the problem that we don’t know which banks
have sub-prime losses, and the banks themselves may not even be
sure.
But the second and more important problem for shares is not
caused by banks, but hedge funds.
Hedge fund calls
They have typically borrowed money to invest (and they’ve
often borrowed shares and
other securities too).
But terms and conditions apply to their loans – lenders tell the
hedge funds the debt must not rise above a specified
proportion of the total fund.
It would be like your bank telling you that your mortgage can’t
rise above 90% of the value of your house.
Now what would happen if the value of your house fell?
You would have to find some cash to repay some of the mortgage
to ensure it was still not above 90% of the new lower value.
Forced sales
Hedge funds are in that predicament now. The losses they’ve
endured on some investments trigger the need to repay cash to
prevent their loans breaching their terms.
One way for hedge funds to find cash
is to sell shares.
Note that this does not mean the hedge funds are insolvent –
they just need cash, and the easiest way to find it is to sell
shares, pushing down the prices. This potentially could be a bit
perverse, with the market getting into a vicious circle of
falling prices, cash requirements and more falling prices.
If this was the only reason shares were falling, it would
probably mean it was a good time to buy them.
But our list of reasons for shares to fall is by no means
complete yet.
Lending dries up
The third link is that all kinds of bank lending have been
affected by the failure of the sub-prime market.
This is because the whole market in second-hand debt has been
paralysed by the sub-prime problems, with traders barely able to
value
the IOUs in which they have stakes.
This affects the banks, who are sitting on debt they’d like to
sell on, but can’t.
And it affects corporate borrowers, particularly the kind of
borrowers who have been using debt to finance highly-leveraged
takeovers.
Those takeovers have helped prop up the stock market, and if
they now evaporate, the stock market will probably fall.
The real economy
Finally, the tightening of credit conditions in the US
housing market and beyond may have real economic effects that
depress corporate profits.
The world has been very dependent on US consumer spending. If
that diminishes as the housing market and stock markets dive,
then companies are in a pickle, the world over. It explains why
the mining stocks have been among the biggest fallers – if the
world economy slows, we won’t be needing so much of the stuff
they get out of the ground.
The end of the cycle
That’s the list of connections between sub-prime and
equities.
But there are other things going on in equities too.
Most notably, corporate profits are at a high level; and that
might be a sign we are at the peak of a cycle and tougher times
are ahead.
We could have surmised this some weeks ago, but other market
events might have concentrated minds on it.
Will equities fall further?
Well, I’m afraid the one thing lacking from the arguments here
are any numbers.
We might identify the broad issue, but what the traders have to
do is to calibrate them and put a price on them all.
What stock markets are going through at the moment means they
are struggling to do just that. – BBC
 
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