Credit
Fears Spark
Stock Market Plunge
By Patrick Martin
10 August, 2007
WSW.org
Stock
markets worldwide slumped Thursday amid mounting fears that the crisis
in the subprime mortgage lending market is leading to a more generalized
credit crisis. The Dow-Jones Industrial Average, the most widely followed
stock index, ended down 387.18 points, its largest loss in six months
and the fourth triple-digit movement in five days, an indication of
the increasing instability in financial markets.
Thursday’s triggering
event was the announcement by BNP Paribas, the biggest publicly held
French bank, that three of its subsidiaries engaged in trading in US
mortgage-backed securities were suspending operations. This came as
a German central bank meeting was underway to discuss a bailout of IKB
Deutsche Industriebank, a regional bank overexposed to losses in the
US subprime market. At the same time, the Dutch lender NIBC Holding
said it had lost $189 million on United States mortgage investments.
BNP Paribas said that no
redemptions would be made on the $3.8 billion invested in the funds
until it could determine the value of the assets held by them. “The
complete evaporation of liquidity in certain market segments of the
U.S. securitization market has made it impossible to value certain assets
fairly regardless of their quality or credit rating,” the bank
said in a statement.
Securitization is a process
in which a home mortgage is resold by the mortgage lender and then combined
with thousands of other mortgages in packages that are sold to hedge
funds and other huge investment firms in the form of Collateralized
Debt Obligations, or CDOs. The process is so complex, and the distance
so great between the underlying asset—the home—and the paper
held by the investor, that determining the actual value of the investment
under conditions of rising defaults and foreclosures has become problematic.
French stocks fell 3 percent
in afternoon trading, while Germany’s DAX index dropped 2.13 percent
and Britain’s FTSE 100 fell 1.96 percent. The New York Stock Exchange
fell 200 points in its first hour, then rallied, partly in response
to well-publicized interventions by central banks to stabilize the financial
markets.
The European Central Bank
made available nearly 100 billion euros ($130 billion) at a cut-price
4 percent interest rate for bank lenders. It was the first such intervention
by the ECB, which manages the value of the euro, since the terrorist
attacks of September 11, 2001 shut down the New York financial markets
for several days.
After the European action,
the Federal Reserve Bank of New York injected $24 billion into the money
markets by entering into repurchase agreements with major banks. The
Bank of Canada also injected funds into the banking system, and issued
a public statement that “it will provide liquidity to support
the stability of the Canadian financial system and the continued functioning
of financial markets.”
Even President Bush joined
in the confidence-building exercise, issuing a carefully worded reassurance
to the market in the course of his last White House press conference
before embarking on his month-long sojourn in Crawford, Texas. He avoided
the subject in his opening remarks—since that would have underscored
the magnitude of the crisis—and waited until reporters asked his
reaction to the financial upheaval.
In comments that were clearly
rehearsed, Bush declared, “The fundamentals of our economy are
strong.” He added, “Another factor one has got to look at
is the amount of liquidity in the system. In other words, is there enough
liquidity to enable markets to be able to correct? And I am told there
is enough liquidity in the system to enable markets to correct.”
Bush later added—in
another reassurance to Wall Street—that he opposed any proposal
to raise the tax rate on the earnings of hedge fund managers, by taxing
so-called “carried interest” as income rather than capital
gains. While endorsing the billion-dollar incomes of the big speculators,
he rejected any effort to bail out homeowners facing foreclosure or
huge increases in monthly payments under adjustable-rate mortgages.
But in afternoon trading
in New York, the wave of selling returned, partly in response to further
indications that the subprime lending debacle was having a wider impact.
This included press reports of heavy losses and forced selling of holdings
by North American Equity Opportunities, a hedge fund run by Goldman
Sachs, the huge investment bank.
A letter to investors in
Black Mesa Capital, another hedge fund, noted that one “very large
hedge fund” was liquidating a “massive” trading portfolio.
The letter, reported Thursday by MarketWatch, declared, “‘
Clearly, something is amiss in the markets that few in our strategy,
if anyone, have experienced before.”
American International Group
(AIG), the largest US insurance company and a major mortgage lender,
warned Thursday that defaults on subprime mortgages were increasing,
and that the increased delinquency rate was spreading to mortgages in
the category just above subprime, which AIG terms “nonprime.”
AIG said 10.8 percent of subprime mortgages were 60 days overdue, compared
with 4.6 percent in the nonprime category.
Press reports emphasized
the shock effect of the French banking crisis on Wall Street trading.
According to the Associated Press (AP): “The announcement by BNP
Paribas raised the specter of a widening impact of U.S. credit market
problems. The idea that anyone—institutions, investors, companies,
individuals—can’t get money when they need it unnerved a
stock market that has suffered through weeks of volatility triggered
by concerns about available credit and bad subprime mortgages.”
The AP suggested that the
massive intervention by the European Central Bank had had a boomerang
effect. According to the Associated Press, “Although the bank’s
loan of more than $130 billion in overnight funds to banks at a bargain
rate of 4 percent was intended to calm investors, Wall Street saw the
step as confirmation of the credit markets’ problems.”
Other events this week have
demonstrated the deep-going crisis in the financial system. On Monday,
American Home Mortgage, once the 10th-largest home mortgage lender,
filed for bankruptcy, laying off nearly 7,000 employees, many at its
Long Island, New York headquarters, and suspending most operations.
The giant investment bank
Bear Stearns fired co-president Warren Spector, holding him responsible
for the failure of two hedge funds that were part of the asset management
group he supervised. The two funds, specializing in securities backed
by subprime mortgages, filed for bankruptcy after losing billions, and
last Friday Bear Stearns saw its credit rating lowered.
Figures reported in the financial
press show a wider pattern of credit-tightening. Thomson Financial reported
that sales of high-yield junk bonds fell from $22.4 billion in June
to only $2.4 billion in July, while sales of investment-grade bonds
fell from $109 billion in June to $30.4 billion in July, the lowest
monthly figure in five years.
The Los Angeles Times noted,
“many analysts say the real test will come in September, when
private equity firms and investment banks will need to find investors
for an estimated $330 billion in bonds and loans needed to finance corporate
buyouts that already have been announced.”
The economics columnist for
the Washington Post, Robert Samuelson, normally a free-market true believer,
expressed the gloom settling in among financial observers. In Thursday’s
column, written before the latest market plunge, he bemoaned the almost
incomprehensible complexity of the mortgage securitization process:
“The peril is that so much has changed so quickly that no one
knows how the system operates. It’s often roulette. Monday’s
defensible investment may become Tuesday’s silly speculation.
Global markets are interconnected, and financial conditions are tightening.
Some hedge funds—including foreign funds—have suffered huge
losses on US subprime mortgages. These could harm banks that lent to
hedge funds. Up to a point, losses are inevitable and desirable. They
remind investors of risk. But too many losses—too much fear of
the unknown — can trigger a chain reaction of selling and credit
contraction. This must worry the Federal Reserve and other government
central banks.”
Another Post business columnist,
Steven Pearlstein, wrote: “Meanwhile, at hedge funds, insurance
companies and the big Wall Street banks, masters of the universe are
sweating bullets over what they are going to tell investors and regulators
about all those assets on their balance sheets that, suddenly, nobody
wants to buy. They include credit swaps and other fancy derivatives,
along with loans to private-equity firms for corporate buyouts.”
Pearlstein was scathing about
what he termed the Bush “administration’s Katrina-like response
to the meltdown in the mortgage market, which has spread well beyond
sketchy subprime loans... when, as result of market and regulatory failures,
millions of Americans face the prospect of losing their homes, jobs
or retirement savings, you’d expect the government to show a bit
more urgency and candor about the problem, and more creativity and leadership
in addressing it. This is hardly the time to head for the ranch and
the beach and leave everything to Mr. Market.”
Leave
A Comment
&
Share Your Insights
Comment
Policy
Digg
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.