Is The Sub-Prime Crisis Really Behind Us?

Source : The Business Times, October 4, 2007

THE fact that the world - its richer countries at least - has been living through a bubble economy period financed by junk (sub-prime) mortgages and funny money (carry trade) borrowing should be obvious enough to anyone observing events over the past few weeks.

But anyone who doubts it need only consider the startling fact that the number of millionaire families in the world grew by no less than 14 per cent to 9.6 million in the space of last year alone. These super-rich individuals now control one third of the estimated US$100 trillion in global financial wealth, according to the Boston Consulting Group in a new study on the subject this week. This is obviously a massive indictment of the failure to distribute wealth more evenly. But the way in which the stunning jump in the number of millionaire families came about is also something that should set alarm bells ringing.

Most of the new wealth came about through increases in the value of stocks, bonds and other financial instruments as global stock markets rose in value on average by 20 per cent, with the strongest wealth gains accruing in America where the equity cult is most entrenched. Not only the super-rich but also the merely 'better off' had a ball in 2006, as total assets held by households with US$100,000 or more leapt from US$51 trillion to near US$85 trillion.

If all this isn't evidence of a bubble, then it is hard to know just what is. But what goes up must come down, and bubbles burst as surely as they form. Or have we discovered some new form of gravity-defying wealth creation mechanism now - an infinitely inflatable bubble?

Looking at the behaviour of markets this week, it appears that the more credulous among investors are being lulled into believing that we have. In this promised land of milk and honey there is no such thing as a financial burst or bust. Descending bubbles simply float down to earth, bounce lightly off the ground and soar skywards again like hot-air balloons being given a fresh charge from the gas jet. Only in this case, the hot air is replaced by financial liquidity supplied in abundant quantity by kindly central bankers who never want to see a hard landing.

Markets are climbing again, as though the sub- prime mortgage market crisis and all its attendant horrors - in the shape of seized- up money markets, runs on banks or other financial institutions, massive mark-downs of un-tradeable financial assets and balance sheet damage all round - had suddenly become a thing of the past. Central banks have taken care of things by covering the ugly debris in a sea of fresh liquidity. Time to party again.

Amidst this new euphoria, an odd and rather worrying thing happened the other day when no fewer that three Japanese government ministers all warned at the same time that fallout from the sub-prime mortgage market debacle might not be over yet. It was not so much what they said as the fact that they said it. Such people usually see it as their job to utter bland, confidence-boosting statements, so when they do say what others of a sane turn of mind already suspect, something clearly is afoot.

It seems likely that the trio - Finance Minister Fukushiro Nukaga, Financial Services Minister Yoshimi Watanabe and Economics Minister Hiroko Ota - were flagging concerns that there may be more nasties yet to come for Japanese banks and other financial institutions, in the shape of write-downs from the sub-prime fiasco.

If there is one thing more risky, or plain daft, for investors to do than to pile back into equities as if there were no yesterday and no tomorrow, it is to build fresh speculative positions by shorting the yen against other currencies (the carry trades). The yen has nowhere to go but up in the medium term, while the US dollar is already on the skids and the Australian and New Zealand dollars favoured by carry trade enthusiasts will slide again against the yen.

Meanwhile, back in the never-never land of sub-prime mortgages, things are not looking good. Sales of second-hand homes dropped by a surprisingly large (to some) 6.5 per cent in August. Morgan Stanley has announced that it will cut 600 jobs in its residential mortgage division, a quarter of the workforce. Anyone who thinks that is a detail should note that two million of the seven million new US jobs created in recent years were connected with real estate.

As the housing sector turns down, along with consumption-financing equity withdrawal by US home owners, the danger of a US recession will grow and with it a slowdown in the world economy and in global capital flows. Irrational exuberance will evaporate in stock markets around the world and liquidity will drain away like so much milk and honey. The only consolation is that a lot of those new paper millionaires will find themselves joining the world or ordinary mortals once more at the new dawn of reality.