Of credit Bubble Underlies Stock Market Turbulence
By Barry Grey
02 August, 2007
stock exchanges are gripped by extreme volatility, with wild swings
in share prices. On Tuesday, the New York Stock Exchange saw a nearly
300-point shift in the Dow Jones Industrial average from positive to
negative territory during the final 40 minutes of trading. The Dow finished
the session down 146.3 points. That sparked sharp declines in Asian
and European markets on Wednesday.
A nervous New York exchange
moved back and forth from positive to negative for most of Wednesday,
and then gained nearly 200 points in the final 40 minutes of trading
to end the day up 150.38. The broader Standard & Poor’s 500
index experienced a move of 1.9 percent between its high and low for
the day—an extraordinary swing for a single trading session.
The turmoil on markets this
week followed last week’s plunge on Wall Street, with the Dow
Jones average losing a combined 585 points on Thursday and Friday. Since
hitting 14,000 on July 19, the Dow has lost about 638 points, or 4.6
percent, wiping out hundreds of billions in share values.
The sudden volatility on
stock exchanges resembles the fever chart of a delirious patient. It
reflects fears that the near-collapse of credit markets linked to subprime
US home mortgages is spreading more broadly and leading to a major contraction
of credit throughout the economy.
Under conditions where cheap
and plentiful credit—much of it based on high-risk investments
and speculative corporate buyouts—has been the indispensable ingredient
in the stock market boom of the past several years, a credit crunch
threatens to precipitate a wave of bankruptcies among corporations,
hedge funds and private equity firms, and major commercial and investment
banks both in the US and internationally.
Already big banks are issuing
margin calls to shaky hedge funds heavily invested in home mortgages
and demanding that existing loans be restructured, with higher interest
rates. There are reports that banks are cutting back on loans more generally,
in part to shore up their own defenses against the prospect of billions
in loans they have extended going bad.
The sudden downturn on Tuesday
was precipitated by signs that the crisis in the home mortgage market
is intensifying. American Home Mortgage Investment Corp., the tenth
largest US mortgage lender, announced it might be forced to liquidate
assets, sending its shares down more than 90 percent. The company said
increased margin calls—demands for more cash or collateral—from
its lenders had rendered it unable to finance the mortgages.
In addition, two home loan
insurers announced that their combined stake of more than $1 billion
in a mortgage company called Credit-Based Asset Servicing and Securitization,
or C-Bass, might be worthless. C-Bass, like American Home Mortgage,
has been hit with margin calls from Wall Street banks and brokerages.
Finally, Bear Stearns, which
earlier this month was forced to close down two hedge funds heavily
invested in securities linked to subprime mortgages, announced that
a third hedge fund had suffered losses in July and that requests from
investors to redeem their stakes in the fund were not being honored.
The news that the Bear Stearns Asset-Backed Securities Fund was in trouble
was all the more unnerving because the $850-million fund has only a
small fraction—less than 1 percent—of its investments in
subprime mortgages. Its difficulties confirm that defaults and foreclosures
are not limited to the high-risk subprime sector, but are spreading
to the prime and near-prime mortgage markets.
The international scope of
the crisis was demonstrated by the announcement from Australia’s
Macquarie Bank on Wednesday that retail investors in two of its funds
face losses of up to 25 percent. And Deutsche Bank said it would suffer
losses as a result of the subprime crisis and the broader credit crisis.
Worries over a credit crunch
were compounded with negative reports on the general economy. Growth
at US factories slowed unexpectedly, according to the Institute for
Supply Management’s manufacturing index reading for July. The
gauge, which moved to 53.8 from 56.0 in June, showed the weakest gain
in four months.
The National Association
of Realtors index for pending sales of existing homes rose at a seasonally
adjusted annual rate of 5 percent to 102.4 in June from May’s
97.5. But the index was 8.6 percent below the level of June 2006.
Auto makers posted sharply
lower July US sales, attributing the downturn to the fall in the housing
market and high gas prices. General Motors said July light-vehicle sales
dropped 22 percent from a year ago. Ford posted a 19 percent drop in
sales of cars and light trucks. Chrysler Group reported an 8.4 percent
decline to its lowest level in four-and-a-half years, and Toyota posted
a 7.3 percent decrease for the month.
A column in Wednesday’s
Washington Post by Steven Pearlstein outlines the far-reaching implications
of the credit crisis that underlies the fevered state of global stock
exchanges. Pearlstein writes:
“The higher cost and
tighter availability of credit is being felt worldwide, with impacts
on Australian hedge funds, German banks, Russian oil companies, commodity
prices in Africa and the government budget in Argentina.
“As this so-called
repricing of risk unfolds, don’t pay too much attention to the
stock market... The real action is in credit markets where bonds, bank
loans, financial futures and all sorts of newfangled derivative instruments
are traded... What concerns people like Buffett is how much leverage
there is in credit markets—how much debt is being used to buy
“In the simple model
of yesteryear, a bank would essentially borrow money from its depositors
and lend it to households or businesses that needed loans. For every
dollar it lent out, however, the bank was required to set aside some
of its own money in reserve to cover losses it might suffer if some
loans were not repaid.
“But all that went
out with deregulation and the rise of financial engineering. Big banks
now borrow most of the money they lend by selling bonds to investors.
And most of the loans they make do not remain on their books, but are
immediately packaged with other loans and sold to buyers such as hedge
“Unlike banks, hedge
funds are under no obligation to maintain minimal levels of equity,
so they can buy these instruments (that is, make loans) with as much
borrowed money as anyone is willing to lend them. And because they don’t
have to disclose their investments, no regulator knows how much debt
is in the system or where it is concentrated.
“By one estimate, for
example, more than half the loans used to finance corporate takeovers
are now packaged with other loans and sold as ‘collateralized
debt obligations.’ And among the big buyers of CDOs are investment
banks that package them with other CDOs and sell them again. Those are
The article goes on to explain
that “this financial engineering has encouraged debt to be piled
on debt, making the system more susceptible to a meltdown if credit
suddenly becomes more expensive or unavailable. And that’s precisely
what’s been developing over the past several weeks.”
The author then points to
the heart of the crisis—the exposure of the major banks to potential
loan defaults. “As this credit-market drama unfolds,” he
writes, “the big banks and Wall Street investment houses will
move to center stage. According to the asset managers at Barings, these
institutions have committed themselves to $500 billion in ‘bridge’
loans to finance corporate buyouts, with the expectation that they could
quickly resell their loans at a profit. But several recent offerings
have had to be pulled because of a lack of buyers, and there is a good
chance that the banks will either be forced to sell many of these loans
at a discount or hold them on their own books and write down their value.
“The extent of such
writedowns won’t become apparent until the third week in October,
when the banks and brokerages report their third-quarter earnings. But
if the market for takeover debt doesn’t rebound by then, these
blue-chip institutions could be looking at losses in the tens of billions
An article posted Wednesday
on the Wall Street Journal Online web site notes that the big banks
are already responding to their inability to resell loans extended to
hedge funds and private equity firms engaged in corporate buyouts by
tightening or withdrawing credit from other companies. “Big banks
facing the prospect of taking on billions of dollars in buyout-related
debt this fall,” the Journal writes, “are starting to clamp
down on lending to companies that need to refinance loans or restructure
their balance sheets.
“The tight-fisted approach
shows how banks’ willingness to back leveraged buyouts during
the frenzied deal-making of the first half of the year could hurt companies
with more ordinary funding needs now that efforts to finance those deals
are running into trouble.
“As banks rein in riskier
lending, companies could find themselves starved of capital to refinance
loans that are coming due or to overhaul their businesses. The result,
experts say, is that some struggling companies may be forced to seek
bankruptcy protection—a development that would exacerbate bond
market turbulence and could ripple through the broader economy.”
This is a scenario for a
downward, self-perpetuating spiral into a slump of potentially massive
Share Your Insights
it! And spread the word!
Here is a unique chance to help this article to be read by thousands
of people more. You just Digg it, and it will appear in the home page
of Digg.com and thousands more will read it. Digg is nothing but an
vote, the article with most votes will go to the top of the page. So,
as you read just give a digg and help thousands more to read this article.