Subprime mortgage troubles in the US have been reverberating through stock markets across the world. What is even more worrisome is that the worst may be yet to come.
Subprime mortgage loans are those given to those with dubious credit histories. With the real estate market booming and interest rates at an all-time low, American banks went on a lending spree in the first half of the decade. But now, with the real estate bubble having burst and interest rates going up, subprime mortgage loan default rates have increased.
The past two decades have seen low inflation and low bond yields, driving interest rates the world over to historically low levels, thereby impacting the saving and spending behaviour of consumers and companies.
Companies have massively leveraged their balance sheets for takeovers and inorganic growth. Many public listed companies have borrowed heavily to buy back their own shares, in an attempt to boost their earnings per share. Consumers have borrowed and spent, throwing caution to the wind, thus spawning one of the biggest consumption booms ever. A significant share of these borrowings has gone into purchasing houses, feeding the real estate boom.
The real estate boom, in turn, generated a positive wealth effect, which first lifted US household consumption to a new trajectory and then sustained it at that level. This, coupled with robust economic growth in China and India, resulted in commodity prices touching historic highs. Buoyed by the positive feedback of all these, global stock markets, especially in the emerging economies, breached their highest levels.
The period also saw the emergence of private equity firms as major players in the global financial markets, with far-reaching consequences. From less than $10 billion in 1991, private equity funds have gone on to raise more than $459 billion in 2006, and are expected to raise more than $500 billion this year. The private equity funds’ share of global mergers and acquisitions (M&As) has grown from 2% in 1998, and just 4% in 2001, to more than 25% in 2006, and more than 35% in 2007.
The private equity-led M&As and leveraged buyout boom in the US and Europe have been driven mainly by the prevailing low interest rate regime and the massive growth of structured credit derivatives such as collateralized debt obligations. Private equity funds have borrowed money heavily from banks and the capital market, and either purchased under-valued companies or taken a large number of public companies private. The credit markets have given these banks and other lenders the ideal platform for transferring credit risks from their balance sheets, thereby enhancing liquidity. The low rates have also meant that investors, especially the high net worth ones, are forced to look out for more remunerative alternative investment options such as private equity.
All the good news from the global financial markets generated a virtuous cycle that lifted the business cycle to its peak. In fact, in many ways, this business cycle can be interpreted as the climax of a process that saw the emergence of financial markets as the critical determinant in the fortunes of the global economy.
Now, dark clouds are gathering on the horizon. The business cycle appears to have passed its peak and corporate profits in the US are already showing signs of slackening. The private sector, especially in the US, is badly positioned to climb down from the peak of the business cycle.
The real estate bubble has burst and the subprime mortgage lending market has started unravelling, adversely impacting the global financial markets. Witness the recent collapse of funds floated by investment banking majors Bear Stearns and Goldman Sachs. If inflation concerns and the weak dollar push up interest rates further, it could spark off massive mortgage defaults.
Anticipating a rise in interest rates, the bond markets have fallen, raising the cost of borrowing. The high interest rates could squeeze investment in the manufacturing sector, where capacity utilization is at its peak. The rising interest rates and the consequent higher interest repayments, coupled with the lower real estate asset values, will slacken the capital gains based on consumption growth in the US, as the reverse of income effect begins to exert itself.
All this will hurt private equity firms and the banks which have lent to them, thereby setting off ripples in the global financial markets. The over-leveraged takeovers and mergers by private equity firms, once hailed as testimony to the genius of modern financial engineering, could look foolish. This could lead to a contagion in the entire financial sector.
The subprime problem may, therefore, be only the tip of the iceberg. The private equity and even the prime mortgage lending boom could be on the way to getting deflated. The multiple effects of a weakening dollar, rising US current account deficit and bond yields, and the resultant pressure on interest rates, will hit investment and, hence, the economy. The equity markets cannot stay insulated—and are already feeling the heat. In any case, we are looking at interesting times ahead.
Gulzar Natarajan is a civil servant. These are his personal views. Comments are welcome at firstname.lastname@example.org