There are now daily reports of US and other financial groups reporting billions of dollars in losses from dodgy US subprime mortgages and associated credit derivatives.
Financial groups in Europe, Britain, Japan and even the US have been affected. but the main damage is appearing in the US where cash management accounts, the investment funds of states, towns and counties, not to mention corporate pension funds and the big names in finance like Merrill Lynch, Bank of America, Citigroup, Barclays, UBS are being revisited by big losses and the prospect of more to come.
It's the credit crunch mark two, a replay of the August freeze, but without the drama of financial markets being hurt so violently. Instead its a steady erosion of value and earnings. We in Australia, facing towards Asia, will hopefully escape the full impact as China booms. But should one of those giant US groups suffer problems, then it could worse before conditions get better.
But the return of the pressures is causing increased volatility in the Australian dollar, the prices of major commodities such as copper, gold and oil, and driving US Government debt yields lower.
The Aussie dollar fell overnight by more than a cent to under 89 USc as the subprime problems continued to dominate US and UK markets.
The prices of US financial stocks have fallen 16% this year while the broader market is up. Our banks are riding out the storms.
The AMP's Chief economist, Dr Shane Oliver takes a look at the return of the subprime debacle.
It seems that we have only just recovered from the big correction in shares into mid-August and yet share markets have been hit by another bout of weakness.
From their recent highs to their lows in the last few days US shares have fallen 8%, UK shares 7%, European shares 5.5% and Australian shares 6%.
Asian shares have fallen around 9.5% (after a 39% gain since mid-August) and Japanese shares have had a 14% fall with the stronger Yen clearly taking its toll. This is the third major correction this year led by the US sub-prime mortgage crisis (i.e. rising defaults amongst low quality borrowers).
The first was in February, then August and now. This is starting to feel like Groundhog Day!
The latest share pullback reflects a range of factors:
* Losses on residential mortgage backed securities -notably sub-prime mortgages – and related investments are leading to big asset write downs, by US investment banks in particular. So far, write offs by major organisations amount to about $US50 billion.
There is talk of much more to go and the rumour mill has been in overdrive. Rough estimates based on potential default and loss rates for US mortgages suggest big losses. If defaults reach 20% on sub-prime mortgages, 7% on Alt-A mortgages (which are basically low doc loans) and 1% on prime which all incur ultimate losses of 35% then total losses could be as high as $US150 billion.
Financial markets have already moved to price this in and in many cases appear to be assuming an even worse outcome (e.g. some US residential mortgage backed securities – i.e. pools of mortgages bundled into tradable securities – are now priced such that an investor would break even if there was a massive 45% default rate and a 90% loss rate on the underlying mortgages).
What we are now seeing is financial organisations move to reflect this in the value of their assets, hence the big write offs. But as we have seen with market pricing the likelihood is that write offs will end up going further than the actual likely recovery rate for the investments.
* This is adding to fears of a serious credit crunch as asset write-downs will slow the ability of banks to make loans which will in turn make the US housing downturn worse. While conditions in credit markets have improved since August they remain a long way from normal. Funding for asset backed commercial paper, particularly mortgage-backed securities, remains very weak. Reflecting investor risk aversion, the yield gap between the 3 month $US lending rate between banks and 3 month US Treasury Bill yields remains unusually wide. In fact since late October this gap has spiked higher again as credit worries have re-intensified.
* Worries about the US economy are intensifying as the US housing downturn is showing no signs of a bottom and the risk of a flow-on to consumer spending rises.
* At the same time the surge in the oil price since August adds to pressure on the already vulnerable US consumer and global growth generally.
* This is all occurring when the Fed is seen as preferring to leave interest rates on hold at its next meeting. Investors fear that the Fed will be less willing or (thanks to the inflation threat from higher oil prices and the lower $US) less able to rush in with further rate cuts.
* In addition, the recent acceleration in the US dollar's decline has also weighed on share markets on fears that it has gone from being benign to becoming a crisis as a collapsing $US may lead to a rush out of US assets and at the same time put pressure on economic growth in other countries, e.g. Europe and Japan.
Risk has gone up, further weakness is possible
To be sure, uncertainty about the outlook has gone up:
* The risk of a US recession is high and rising and this is adding to downwards pressure on US profit expectations. The credit crunch may have faded but it certainly hasn't gone away. There is more bad news to come in the US housing market with roughly numerous sub-prime borrowers due to reset to higher mortgage rates.
The combination of falling house prices and higher energy prices is sure to have some dampening impact on consumer spending going forward.
Finally, surprisingly strong US economic growth over the last two quarters by robbing from future growth has actually increased the chance of a co
