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Global stock markets tentatively recovered yesterday from Tuesday’s ‘Shanghai Surprise’ as The Telegraph dubbed it.
In the US, the Dow Jones rallied by 52 points – still a long way off the 400 or so plunge seen on Tuesday. The FTSE 100 didn’t do so well, ending another 114 points off, at 6,171, though the rally on Wall Street prevented even worse carnage.
But it’s becoming more and more apparent that the country we really need to be worrying about is the US, not China. Fourth quarter GDP growth was revised down sharply from 3.5% to 2.2% – and there’s more evidence that the sub-prime mortgage meltdown is steadily getting worse…
Stock markets rallied in the US yesterday. But as the bulls were taking advantage of what they saw as a buying opportunity, the creeping cracks in the global credit bubble continued to widen.
One of the country’s largest sub-prime mortgage lenders, Fremont, warned suddenly that it would delay its results. No reason was given, but in light of HSBC’s recent profit warning, and the fact that nearly two dozen sub-prime lenders have now gone to the wall in the past two months alone, no one thinks the news is good.
“When I heard the news I gulped,” Sky Capital analyst Theodore Kovaleff told The Telegraph. “There’s definitely a worry that they may have had difficulty selling packages.”
Mr Kovaleff is referring to the way that sub-prime lenders parcel up batches of mortgages into bonds, called Mortgage-Backed Securities (MBSs). Up until very recently, hedge funds and other major investors couldn’t get enough of these MBSs, which only encouraged lenders to rush out and write more business any way they could.
This lead to a drop in lending standards – interest-only mortgages (considered fairly exotic in the States), mortgages that start with a low teaser rate then soar after a couple of years, mortgages where you don’t even pay the full interest bill, meaning the amount of capital you owe actually grows the longer you have the mortgage – all of these high-risk products have been dished out to even higher-risk prospects, many of whom have been merrily lying about their incomes to get on the housing ladder.
So lenders really only had themselves to blame when more people than they expected turned out to be completely unable to afford their mortgages and started to default on the loans almost as soon as they got them.
Now, the main reason for such slack lending standards was that the sub-prime lenders could offload the mortgages into these MBSs, apparently dumping the risk on whoever bought them. Trouble is, there is a clause written into these packages so that if they go bad too quickly, the MBS buyer has the option to send the MBS back to the originator – to dump the risk right back on the sub-prime lender, in other words.
The sub-prime lenders borrow the money to write the mortgages in the first place from banks (often the lender is just a unit of a big bank – such as with HSBC). So the bank funds the sub-prime lender, which then parcels up the mortgages, and sells them onto a hedge fund. In this way, the bank reckons it’s shifted all the risk off its balance sheet and onto someone else’s.
But if enough of the investors who bought the MBSs ask the sub-prime lender for a refund, then the lender rapidly runs out of money. At the same time, the banks see all these loans going bad and stop funding any further mortgage business. Result? The lender goes to the wall. And once it’s gone to the wall, anyone looking for a refund on the dodgy MBS they’ve been sold is going to be waiting for a very long time.
So the upshot is, no one wants to buy sub-prime mortgages any more. And that means no one will be writing them either. And if you pull the sub-prime home buyers out of the US mortgage market, that kicks yet another prop away from under US property prices, which are already down around 9% year on year.
There’s more on the US sub-prime market in the latest issue of MoneyWeek, out tomorrow. If you’re not already a subscriber, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.
Turning to the wider markets…
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UK stocks closed in the red again yesterday as the mining and banking sectors came under pressure. The FTSE 100 index of leading shares closed down 114 points, at 6,171, although the beginnings of a recovery on Wall Street saw the average pull back from a morning low of 6,166. The broader indices were also lower. Mortgage provider HBOS was the day’s biggest faller on concerns over shrinking margins, with peer Barclays dropping in sympathy. However, Whitbread was rewarded for a solid trading update with gains of over 1%. For a full market report, see: London market close.
Elsewhere in Europe, the Frankfurt DAX-30 headed 104 points lower to close at 6,751, led by utility stock EON. In Paris, the CAC-40 ended the day 72 points lower, at 5,516.
On Wall Street, stocks rallied on Wednesday as soothing words from Fed Chairman Ben Bernanke and a partial recovery on the Shanghai stock market calmed investors. The Dow Jones gained 52 points to close at 12,268. The S&P 500 ended the day 7 points higher, at 1,406. And the Nasdaq closed 8 points higher, at 2,416. However, the major indices ended February as a whole in the red.
Gains on Wall Street were not enough to calm Asian markets, though. The Nikkei slid 150 points lower, ending the session at 17,453, whilst in Hong Kong the Hang Seng closed 304 points lower today, at 19,643.
Crude oil was last trading at $61.48 a barrel this morning, whilst Brent spot was at $60.64 in London.
Spot gold rose as high as $677.20 in Asia trading, though had fallen back to $670.90/oz this morning. Silver had slipped to $14.13/oz.
And in London this morning, the Royal Bank of Scotland announced an expectation-beating 12% rise in second-half profit, having seen particularly strong growth in its corporate lending unit. The firm is to increase its full-year dividend by 25%. RBoS shares had climbed by as much as 65p in early London trading.
And our two recommended articles for today…
What happens when global liquidity dries up
– The rising tide of liquidity has led to the unprecedented growth of hedge funds and private equity deals, yet there are any number of threats to these investment vehicles. If any of these threats were to materialise, what would happen in the markets? Click here to find out: What happens when global liquidity dries up?
How to handle the market sell-off
– The Shanghai Composite registered its largest single-day drop since February 2007 on Tuesday, triggering negative reactions in markets around the world. For more on whether is was profit-taking or panic-selling – and what it means for your portfolio – read: How to handle the market sell-off