-------------------------------------------------------------------------------- What has actually led to the turbulence in the US economy, and its global impact? A quick look at the basic issues and the outlook for the near future.
-------------------------------------------------------------------------------- Why did Lehman, Freddie and Fannie and the other banks get into these difficulties? The root problem for Lehman and others affected was not realising that the US was in a housing bubble and therefore, once the bubble burst, there could be major losses. A secondary factor was the way the underlying mortgages were engineered into complex securities such as Collateralised Debt Obligations (CDOs), which became impossible to value once house prices started to fall. The problem in a bubble is that almost everyone starts to believe the underlying 'mantra'. During the tech bubble, the mantra was that "the sky is the limit for the new economy". During the housing bubble it was that "national house prices never fall." Why were banks unable to deal with the housing downturn and financial crisis? Banks and other financial institutions have been trying to deal with the problems since August 2007 (at least) though some moved faster than others. Hedging problem exposures was difficult because the obvious hedging mechanisms such as the CDX index (a credit derivative combined index) sold off early. Selling exposures has been difficult except at very low prices, which did not look attractive to many institutions. Merrill, for example, was able to sell some CDO exposure recently only at about 22 cents on the dollar. B ut any of these actions by one bank makes the problem for the others more difficult. This is the nature of a systemic crisis. On the plus side, banks have raised substantial amounts of capital over the last year, which has helped to reduce the risks. Unfortunately, in aggregate, they still have more write-downs than new capital. Moreover, in the current environment, most of them feel they need to operate at much more conservative capital ratios than in the past. Hence, the pressure to continue to de-leverage and make balance sheets risk-free. Do you agree that there were good reasons to pass the Glass-Stegall Act in the 1930s and whether there might be good reasons to enact similar legislation again? The Glass-Stegall Act was passed after the 1932-33 banking crisis because of the perception that integrated banks, comprising investment banking activities with commercial banking including deposit taking, were dangerous. The concern was that losses on investment bank activities might cause a run, and bring down the whole institution. So the activities of the two types of institution were separated. Glass-Stegall was relaxed over the last 20 years so that commercial banks are now widely involved with investment bank-type activities. The way things are going currently, we are moving even further away from the Glass-Stegall division, with JP Morgan taking over Bear Stearns and Bank of America taking over Merrill Lynch. We may well see tighter regulation of banks in coming years but I doubt if it will be based on the Glass-Stegall division. What I think we will see is much less leverage and risk taking, in all institutions as they run at a much lower level of risk. This means a higher cost of capital and less financial engineering. It also means a smaller financial sector. In layman terms, what really is the worst case scenario for the global banking system? The worst case scenario would be a general panic, akin to what happened in the US in 1932-33 when a huge number of banks failed and the financial system virtually broke down. We are a very long way from that. There is still plenty of room for central banks to cut interest rates, even the Fed. Japan took rates down to zero per cent during its financial crisis. Our forecast is for 1 per cent Fed Funds rate by next year. There is also the potential, if necessary, for governments to step in with guarantees for creditors or to directly buy assets. The inflation hawks might worry about these actions which is why they are a last resort. But the fundamental problem facing the world now is deflation, not inflation. What do you think US mortgage rates will look like 12 months from now? The two components that determine fixed mortgage rates are the long-term government bond yield and the spread charged over it. Government bond yields are already low, though they could certainly go much lower if the economy weakens further and inflation fears recede as we expect. Spreads look set to stay higher than in the past. The perception of risk in mortgage lending has turned 180 degrees since the bubble years. Moreover, the cost of funding has risen because of the financial crisis and because of the caution among investors in holding mortgage-backed securities. In a year's time, the 30-year mortgage could be in the 5-6 per cent range. How long will it be before the economic outlook for North America is no longer dominated by Conjecture about the bottom in housing prices? Probably not until we can see the bottom for house prices, or at least it looks as though we are getting near. Bear markets in housing typically last four-five years but the really rapid rate of decline occurs in the middle period. US house prices peaked in June 2006 and started to fall rapidly at the end of 2007. They will continue to fall rapidly for another year but then the pace of decline will slow. Markets expect a total decline on the Case Shiller indices (home price indices) of 30-40 per cent so we are about half way. While the extent of the fall in home prices is crucial for the financial system, there are other critical uncertainties for the economy. We can be sure that the savings rate will rise more, and there will be a greater fall in house prices, but how much is a big unknown. Another critical uncertainty is what happens to oil prices. If oil prices stabilise below $100, this will be a considerable relief for the US consumer. This will also, by reducing inflation expectations, make it easier for the Federal Reserve to cut interest rates further if necessary. (Sourced from Monthly commentary - ING Investment Management India) http://www.thehindubusinessline.com/iw/2008/10/05/stories/2008100550491300.htm --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [EMAIL PROTECTED] For more options, visit this group at http://groups.google.com/group/kences1?hl=en -~----------~----~----~----~------~----~------~--~---
