The Sub-Prime Infection: How Serious?

Source : The Business Times, August 8, 2007

ABOUT of made-in-America financial turmoil is rattling markets worldwide. One reason why the gyrations are so wild is that the credit problems that started in the US sub-prime mortgage segment have neither peaked nor revealed their full depth.

The bad news is coming out in dribs and drabs. The latest casualty was American Home Mortgage Investment Corp, which filed for bankruptcy protection on Monday. Several other sub-prime mortgage lenders, as well as some high-profile hedge funds, have failed.

Many other institutions across the globe, including those in Singapore, have been compelled to explain their exposure to the so-called collateralised debt obligations (CDOs), financial instruments in which many sub-prime mortgage assets were packaged.

A German bank has had to be bailed out to cover its losses from US$24 billion sub-prime investments. Fund managers and credit analysts fear more unpleasant disclosures from banks and mutual funds alike. 'It's a bit like discovering Easter eggs,' Boris Boehm, a money manager at Nordinvest in Hamburg, told the New York Times. 'There are a lot of eggs hidden around here. You'll be hearing more and more about these problems.'

Consumer demand in the euro zone could be affected, a European Central Bank Governing Council member said yesterday. However, US Federal officials have indicated that housing market weakness and financial market volatility have not spilled over into the broader economy. But this may well change in the coming months. A 'relentless increase' in defaults on sub-prime mortgages could lead to foreclosures on some 1.5 million borrowers and losses of US$100 billion, according to Credit Suisse.

Borrowers may end up defaulting on US$180 billion to US$220 billion of sub-prime US home loans. About US$1 trillion of such mortgages are outstanding. It is hard to imagine how all this could not have unpleasant macroeconomic effects.

Other than the wild swings in the markets, Asia has so far not produced any significant bad news. But the worst may be yet to come. If the magnitude of the crisis is way beyond what has been revealed, a recession in the US is a real possibility.

And even a technical recession could erase a couple of percentage points from Asian growth rates.

As yet, central bankers have not sounded any alarm. Investors need to keep their sang-froid, Jean-Claude Trichet, the president of the European Central Bank, said last week. That's a tall order, amid the uncertainty.

But what central banks actually do is more important than what they say. So far, the US Federal Reserve has not changed rates. How much longer it maintains the status quo remains to be seen.

Meanwhile, how much power the emerging Asian giants, China and India, wield in these circumstances is an open question. To what extent can these fast-growing economies help insulate emerging Asia from the effects of financial market turmoil and a US slowdown? It will be interesting to find out.