Opinion

Surreal returns

Finance | William Jensen | 1 Nov 2007

There are many things making investors edgy, says William Jensen.

There is something of a surreal quality about global investment markets. In the space of a few months we have observed the first major cracks open in the infrastructure of investment banking and hedge fund management. We discovered that mortgages advancfed in Arkansas have the potency to precipitate an embryonic banking crisis in the UK, yet here we are with equity market indices indicating high levels of optimism.

It began with the manifestation of distress in the US mortgage market with subprime defaults taking centre stage. Bear Sterns discovered that two of its funds investing in structured credit instruments had been wiped out. The issue is not so much the extent to which US home owners are falling into delinquency, but rather the fear that subprime loans that have been incorporated into complex structured debt instruments will precipitate defaults.

The significance of this is the extent to which structured debt instruments have penetrated the global financial and banking system, and their untried qualities under stress. It is feared that defaulting US subprime mortgages (or their close cousins, automobile and credit card loans) may be the Achilles heel of a significantly larger asset class, including the leveraged loans used to finance private equity buy out transactions.

For investors contemplating strategy and tactics, there is something of a dichotomy between market conditions and the underlying global economy. The liquidity crunch in short term money markets is a function of capital markets and does not reflect conditions in the real economy, which for the moment continues to indicate general good health. Institutions which, until a few weeks ago, were happy to lend and borrow in the short term money markets have bolted their doors and are thought to be hoarding cash in anticipation of having to take originated loans onto their books, rather than securitise them out to the market.

The fact that these large pools of assets are often valued on models and are not marked to market has made those institutions manufacturing, distributing and holding potentially toxic assets suspicious of one another. Zeal to confess has gripped investment banks reporting thirdquarter results and impairment charges against doubtful assets have become a badge of honour. It would require unflinching optimism to believe that this is the end of the structured credit debacle.

Politicians and central bankers have appeared more concerned with restoring confidence to the banking sector and the potential impact on the economy. Commentators, including Greenspan, are anticipating significant declines in domestic housing markets and the UK commercial property market seems to have rolled over. There is the argument that emerging markets can maintain global economic momentum even in the face of a weakening US economy, but that is overlooking the potential hit to domestic savers if their inflated equity markets suffer punitive corrections.

So, back to surrealism. There are many factors that ought to make investors nervous of any false hope so soon after a major shudder in global capital markets. Investment banks and hedge funds have had much more to do with the provision of liquidity across equity, real estate and commodity markets than have central banks and their monetary policies.

The geared effect of structured debt in the global capital markets was demonstrated by the speed with which liquidity dried up at the first sniff of trouble and it is difficult to see why a cut in US lending rates should have a dramatic palliative influence at this point. If the contagion of mispriced default risk in the debt markets and the unwinding of bubblepricing in residential housing continue to spread and even escalate, materially slower economic growth seems inevitable with a consequence for equities.

The best explanation for the robustness of equities is that traditional equity investors were always suspicious of the financial engineering in debt markets. What investors must watch is the link between equity earnings and economic growth. The synthetic world of structured debt may yet prove to have been the rocket fuel of the real economy.

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