PARIS : The link between repossessed houses in the United States and wealthy moneymen around the world is the key to understanding the current stock market turbulence and fears for the world economy. Markets in the United States, Europe and Asia were rattled last week in what could be either the start of a downturn or a simple correction similar to one seen in February this year.
Only three weeks ago, the main US stock index, the Dow Jones Industrial Average, had broken through 14,000 points for the first time in its history, but sentiment has reversed sharply in recent weeks.
The turning point came last month when a US bank, Bear Stearns, spooked the markets with news of major losses and accounting difficulties with its investments linked to risky US housing loans.
Related Video Link : How US homeowners caused global market tremors
Losses by other banks and investment funds have led to what has been termed the "US sub-prime housing crisis," the source of turbulence and uncertainty last week.
Sub-prime loans are housing loans made by lenders to individuals with poor credit histories and are therefore risky.
Following years of booming house prices and cheap credit - interest rates have been low by historical standards - the US housing market is now in reverse with loans becoming more expensive and prices falling.
This has caused high numbers of defaults and repossessions as borrowers, particularly high-risk sub-prime borrowers, struggle to keep up with their mortgage payments.
The human face of the current financial crisis is likely to be a low-earning American, possibly someone who took on a mortgage they could ill-afford and whose mortgage broker did inadequate checks on their ability to repay.
The link between these people and turmoil in financial markets involves a piece of financial trickery that has enabled banks and funds all over the world to make investments that are essentially bets on borrowers repaying their mortgages.
Funds looking for a high-risk, high-return investments have bought unknown numbers of innovative securities called mortgage-based securities (MBS) or asset-based securities (ABS), and their variants such as collateralised debt obligations (CDOs).
Questions about the scale and scope of these investments - i.e. who has bought them and how much are they exposed - has caused volatility on world stock markets with investors waiting to see who has been caught short.
So far, banks in Germany, Australia and Britain have revealed losses and several funds have closed because of severe losses.
The sharp falls on Thursday and Friday were sparked by an announcement by French bank BNP Paribas that three of its investment funds had been suspended because of their exposure to sub-prime loans.
"The big question is what is the overall amount (of sub-prime-linked investments) and this is bad for the markets because if there is one thing that the markets hate, it is uncertainty," Gilles Moec, senior economist with Bank of America in London, told AFP.
So far, so bad - but losses by a few risk-loving investors is only half the story with the real danger to the global economy the consequences that might trickle down to consumers or companies.
Banks are now setting aside cash as a precaution against further losses from their bad investments and have become far more cautious about lending.
This is known as a "credit squeeze," but the fear is that this could become a veritable "credit crunch" in which companies and consumers have inadequate access to loans.
"As private sector banks, in a time of uncertainty, set aside more funds for their own funding needs, we are seeing a shortage of liquidity in the money markets," explained Societe Generale's chief Asia economist, Glenn Maguire.
A shortage of liquidity would restrict the ability of companies, and eventually consumers, to borrow, potentially slowing economic growth worldwide.
As a result, central banks across the world have been pumping money into the banking system by offering loans at attractive interest rates to commercial banks in the hope of forestalling a damaging crunch.
The European Central Bank put a record 94.8 billion euros into the market on Thursday and followed up with another 61.05 billion euros on Friday.
The Federal Reserve for its part pumped US$62 billion into the US banking system since Thursday, intervening three times on Friday to shore up the country's financial system.
For some, the tightening of borrowing conditions is well overdue and the sub-prime crisis is a sting in the tail after years of easy money and lax lending by banks and mortgage brokers.
The consequences for the stock market could be serious, however, particularly given that much of the rise in stock prices in recent years has been caused by aggressive takeover activity by private equity companies.
Private equity groups, investors that specialise in increasing profits at underperforming groups, rely on large amounts of debt to finance their acquisitions and they might now have difficulty finding financial backing.
"There are two things I am more or less sure about," said Philippe Waechter, senior analyst at French group Natexis Asset Management.
"One is that the financing problem in the housing market is going to continue. The other is that on the markets there is going to be a lot of volatility and for the moment one can't say if the low point has been reached." - AFP/ch
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