Let’s look back at 2007: was there no getting round the subprime mortgage crisis? This crisis was certainly the biggest event of recent years for financial markets.
Here’s the way it happened: investment banks packaged together and securitized the riskiest mortgages in the US market.
The rating agencies blessed these deceptively packaged investment vehicles with high ratings thanks to their supposed diversification.
However, even nicely packaged and diversified junk remains junk.
At the end of the chain were the investors, who had put more than a trillion dollars in this asset-backed paper. The most fundamental investment rule of all, according to which greater returns entail higher risk, was simply ignored.
People in real estate have been talking for two years about a correction in the American real estate market.How can it be that the wiliest investment bankers and their clients have, despite that, put so much money into risky mortgages? In a word: greed. The prospect of higher returns inevitably tempted investment bankers to take the higher risk. And they were not alone. At the outset it was the real estate agents, who flogged houses to low-income clients with the promise of supposedly cheap credit. In doing this they often played down the fact that the interest on these loans would automatically increase after two years. The second link in the chain was the house buyers themselves, who looked forward to fat returns from booming house prices without stopping to think whether they would be able to afford the steep increase in interest rates two years later.
And at the end of the chain were the investors, who saw only the high returns and not the greater risks. One thing all these had in common was too much greed and not enough fear.
Were you yourself surprised by the subprime crisis? No, on the contrary. When the hedge fund manager John Paulson brought the problem to our attention in summer 2006, his arguments sounded very plausible.
Lower house prices together with automatically increasing interest rates would lead to an explosion in mortgage payment defaults and considerable losses for the investment bankers. Could it be possible that the highest-paid professionals in the world might not recognise such an obvious problem? Indeed it could, and John Paulson, in foreseeing the collapse of the subprime mortgage market, made by far the most successful deal in financial history.
And where do we go from here? The greatest danger is that the crisis may spread to other credit markets. I’m thinking here for example of the credit card business, but especially of the Credit Default Swaps (CDS). At the end of 2005 the total volume of outstanding CDS’s amounted to 14 trillion US dollars, and this looks like swelling towards 40 trillion by the end of 2007, an enormous sum.
To be sure ,the outstanding net risk is significantly lower than the total volume of this market; however, should one link in the CDS chain get into difficulties, the consequences could be dramatic as a result of the domino effect. The more so, as the most important links in the chain, the bankers and brokers, have already been weakened by the subprimemortgage crisis.
How about the repercussions of the crisis for other parts of the economy? Some talk of a recession in the USA, malicious tongues even of a worldwide one… If the crisis is limited to subprime mortgages, the USA should get away with no more than a black eye. The positive aspect of this crisis is that through securitisation, the risk has been spread worldwide, and with it the damage. If the 300-400 billion dollars had to be written off by the Americans alone, it would certainly cause a recession. Even then, it would be a really grave problem only if other credit businesses were sucked into the whirlpool. And that’s exactly what we expect to happen. It remains true, though, that the effect on the world economy should stay limited. Countries now in the midst of an economic boom, such as China, India and Russia, share a decisive part of the present growth in the world economy, and will still have a positive influence on it over the next two to three years.
Can this crisis even have a positive side to it? Surely. The whole financial sector has become artificially overblown in the last few years. Cheap credit has been available for financing speculative acquisitions and takeovers or for leveraging client portfolios and hedge funds…“irrational exuberance”, in the words of Alan Greenspan. One often hears of “repricing” credit risk; but I would rather call it “rectification of mispricing”. The present crisis should lead to a healthy “deleveraging”.
The share of financial sectors in Stock Exchange indices has risen to 20% over the last few years. My assumption is that this is going to move back towards 10%, where it was in the 1980’s.
What’s your forecast for 2008? The first half of the year may well continue to remain volatile. However, the American Federal Reserve Board (the “Fed”), unfortunately always “behind the curve”, will have to reduce the interest rate still further, even to below 3%, depending on the state of the economy. I count on a hard landing for the American economy in 2008. When the DotCom bubble burst in 2001, Greenspan dropped the Federal Funds rate to 1%, triggering a real estate bubble. Now that also has burst. Bernanke will now in his turn drop interest rates in order to bail out banks and homeowners, thus setting up the conditions for the next stock market bubble. Stocks are at present historically cheap, with many firms making good profits and having healthy balance sheets. I don’t believe we’re heading for a general stock market crash. Good tips in any case are large caps (shares in big companies – Ed.) gold, and commodities both soft and hard…and hands off the finance sector until further notice.
