I have been suffering from sinusitis for the last three months and I feel it is due to the subprime borrowers in the US. Furthermore, the phenomenon does not appear to be contained. Yes, that hapless borrower is a loan defaulter, has lost possession of his house and is also responsible for all that is wrong with the world. That appears a reasonable inference going by the overuse of the phrase, “subprime”.
However, we should not forget that other factors have been more instrumental than the simple act of extending mortgage credit to a borrower who did not deserve one.
If that were the only problem, then the default by such borrowers would have most definitely remained contained. The world has reached this point because these loans were securitized, resecuritized and sold to leveraged hedge funds whose investors were leveraged funds of funds. The central banks of the world kept real rates very low between 2002 and 2004, ignored the reckless provision of leverage by prime brokers (banks) to hedge funds and hedge funds chased returns —unmindful of risks because of the distorted incentive systems and due to competitive pressures.
The involvement of so many players and so much of leverage did not reduce systemic risk but simply allowed it to be hidden and untraceable. That is why central banks of the world had to eat humble pie and provide emergency liquidity to the interbank market last week because banks were not willing to lend to each other at the prevailing interbank rate.
In other words, no bank was willing to lend to another bank at an interest rate that did not offer adequate compensation for the perceived risk of doing so. No one was sure of the hidden risks. That marks the beginning of the end of the chase for “risk-ignored” return as one observer put it.
The infusion of liquidity was the acknowledgement by central banks of the lack of information as to the extent and depth of the risk that still remains in the system. After telling the world they were poised to hike interest rates in September, the European Central Bank (ECB) had to provide emergency liquidity to the tune of $130 billion on Thursday. Had the ECB known of the stress that European banks were under, it would not have signalled a September rate hike. The Federal Reserve, too, after repeating that the situation was “contained”, had to inject liquidity on Friday.
Investors should pay heed to this implicit acknowledgement by central banks that they are no longer in control of the situation. That is a cause for concern, and not celebration.
The second point to note is that the central bank intervention is unlikely to address the root cause of the problem —that the housing market demand and supply imbalance in the US is going to take time to be resolved. Interest rates would be reset higher for many billion dollars of mortgages. Mortgage rates have been hiked even for prime borrowers and many lenders have gone out of business. The remaining ones are unlikely to take chances. The real economy consequences are yet to unfold and these recent central bank actions are unlikely to make any difference to them.
The third point is that America appears to have parcelled off its problem to European investors and that the latter, therefore, are more vulnerable. It may not be necessarily true. It may be the opposite, in fact. In Europe, the problems may be more transparent with banks involved and in the US, it may be less so with more hedge funds involved whose losses reveal themselves slowly and reluctantly.
Nonetheless, this places question marks on the future path of the exchange rate of the euro against the US dollar. Consequently, the recovery of the gold against the US dollar on Friday is a development whose import is not to be missed. It happened despite the euro remaining broadly unchanged against the US dollar from the previous day. It is not too late to start accumulating real alternatives to paper currencies. Investors should note that god-made assets are always more preferable to man-made ones.
Lastly, on the surface, Asia appears to have a wonderful opportunity to show itself off as a superior alternative to the US, which seems to have lost its direction in more ways than one, and to Europe, which appears incapable of stepping out of the shadows of the US.
However, that is not preordained. If Asia uses this period of relative strength to allow the weaker boats to submerge and to strengthen corporate and political governance instead of playing to the gallery with rate cuts and stimulus spending, it could look back at the unfolding crisis in the West as the moment that reshaped global economic and political power.
I, for one, would not bet on that though.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org