Special overview: Trouble in the U.S. (Part 1)

The U.S. markets have not found a consensus since this summer. Naturally, there are various reasons for the uncertainty and different predictions for the future. However, at this point, the majority of the opinions are negative and to be honest, it is hard to find bullish analysts. This report will give an overview, some future estimates and predictions how it could affect the Baltic markets.

 

As we can see from the graph 1, main indices (Dow Jones, Nasdaq and S&P 500) of the U.S. stock market have fallen substantially since July or if to take into account always overreacting Nasdaq, from November. Although prices remained high until the end of the year, despite the uncertainty, they have experienced a sharp decline within a month to date. The reasons are as follows.

 

Graph 1.

 

First I would like to explain some important things.

 

A sub-prime mortgage is a loan, which is given to borrowers who do not qualify for the best interest rates, i.e. they have bad credit record history or their income might not be high enough. Basically, it is a risky loan for both, borrower and lender, as the first has to pay higher interests and the other cannot be sure if they will receive the payments.

 

In general, a sub-prime crisis means that lots of people are not able to service their loans, which could in one point lead to unhealthy cash-flow for banks, which we later refer to as credit crunch. It means that, banks do not receive enough money back from the granted loans to give additional loans and soon have lack of cash, which leads to high interests rates between banks and seriously damages the level of liquidity in the market.

 

First signs that something is wrong came to the minds of investors on the 22nd of February, 2007, when HSBC and some other mortgage lenders announced write-offs in their sub-prime loans. The reaction of the market is clearly visible in the graph 1. However, investors quickly forgot it and the trend turned upwards. On the 2nd of April, a report was published which showed that the U.S. homes sales fell sharply. Not much attention was paid to it, as there was enough positive besides that. Yet more analysts started to warn about possible problems in sub-prime sector. In the middle of May, it was widely accepted that sub-prime crisis would occur yet the size and impact of it was not clear. Volatility in the markets continued to grow.

 

On June 22, Bear Stearns revealed, that it had spent 3.2 billion dollars bailing out two of its funds exposed to the sub-prime market. On 20 July, the U.S. Federal Reserve chairman Ben Bernanke, said to Congress that the sub-prime crisis could cost up to 100 billion. Such a strong statement made the U.S. market heading to south for a while.  For a month, even more banks admitted losses in sub-prime sector. On the 9th of August central banks started to take action by bumping money into the market. Federal Reserve promised to provide as much money as needed to combat the credit crunch. In Europe, ECB pumped over 200 billion euros into the eurozone banking system in 5 days to increase the money market liquidity. On the 18th of September, Federal Reserve decreased interest rate by 0.5%, from 5.25% to 4.75%, which was the first rate cut in 4 years. These radical measures pleased market and the graph 1 also shows the quick rise in the stock prices from the mid-August until the beginning of October.

 

01.10 UBS: 3.4bn dollars write-off in US sub-prime mortgages

05.10 Merill Lynch: 5.6bn dollars write-off in US sub-prime mortgages

15.10 Citigroup: 6.2bn dollars write-off in US sub-prime mortgages

Etc.

 

 

From that point on, massive amounts of write-offs started to occur and from November, banks did not try to hide their losses. It was clear that there was a wide credit crisis, and the catalyst for this was the U.S. sub-prime mortgages. Basically, every large bank announced billions of write-downs in US sub-prime divisions except Goldman Sachs, which so far seems to have escaped the troubles. It must be made clear, that besides American banks, European banks are suffering heavy losses as well, and all of them are linked to the U.S. sub-prime issue. In order to avoid recession the Federal Reserve has made additional interest rate cuts on the 31st of October and the 11th of December, both by 0.25%. Canada’s and UK’s central banks are also cutting rates, to boost the economy. So far, ECB has not changed the interest rate, which has remained at 4%, however during the Christmas period, ECB inserted 500 billion of dollars to interbank credit market, which helped to stabilize the interest rates between banks and bring some confidence.

 

Furthermore, the write-off spree has most probably not stopped yet, so there is more to come, and some analysts, for example bearish Doug Kass, expect the total write-offs to reach up to 175 billion dollars. Goldman Sachs estimates that the total loss for financial sector will be up to 400 billion dollars. At this moment, the write-offs have reached 100 billion line.   On the other hand, central banks are inserting huge amounts into the market and cutting rates, which seems to relieve the unstable situation in the money market. Moreover, they have shown willingness to give more if needed, to avoid the recession. Additionally, most of the banks have issued shares, to gain some capital mostly from Asian partners. For instance, Morgan Stanley will sell 9.9% share of the company to Chinese state investment company for 5 billion dollars to rebuild its capital. Is the credit crunch an opportunity for China to become even more powerful? This is another topic.   What is the real reason behind the US sub-prime problem?   Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do.   In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing, but it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.   Figure 1 Source: BBC News (the picture and text about it is a copy-paste from the web-site, which I think is a good one, and I recommend reading the article for deeper understanding)

From this we can see, that if repayments stop, it will have a chain effect on other parts, and the whole system will crush. This is what is happening in the U.S. at the moment. So, why did the repayments stop? A major problem is that, the sub-prime loans were given already too easily and the risk premium was set too low. Moreover, the contract included a fact that, the first 2 years there is one interest rate and after that 2 years, the mortgage is reset and the new interest will be much higher. Banks did not disclosure it enough and many families could not handle the reset mortgage interest. (Continued Part 2...)