Published on August 13, 2007
On Friday, central banks around the world pumped liquidity into the financial systems to prevent a credit squeeze in the wake of the turmoil. Share prices fell sharply worldwide on panic selling. The US Federal Reserve injected US$38 billion to save the financial system. The European Central Bank pumped in US$84 billion on Friday after pitching in US$130 billion on Thursday. The central bank of Japan injected US$8.5 billion, compared with US$4.2 billion for the Reserve Bank of Australia to alleviate the credit squeeze.
So what is going on? In simple terms, the problems started with the mortgage loans made to sub-prime borrowers in the US that went sour. The borrowers are those who have weak credit histories. But the lenders had been eager to push money into their hands so they could buy new or second homes. Now they are having a difficult time paying off instalments.
The problems do not end there. Mortgage loans had been repackaged as mortgage-backed securities and sold to investment banks and other investors globally. The worldwide markets of mortgage backed securities are huge and rather liquid. The best and brightest of the financiers have taken these mortgage-backed securities and repackaged them with other debt instruments before selling them as collateralised debt obligations (CDOs). The CDOs securities are designed with complex structures, so that some take the first loss when any of the underlying debt defaults while others suffer losses only after the poorer rated tranches lose money.
So when widespread defaults by borrowers became apparent, it hit the underlying value of the mortage-backed securities and CDOs. As investors have exposure to these complex securities, they are going to lose money. This has created a tight credit situation, as banks do not have confidence to lend for fear of bad credit. Without liquidity, it is difficult to value these complex securities. To prevent a credit squeeze, central banks have to inject liquidity to keep the markets functioning. The US Federal Reserve has extended short-term loans through the repurchase market. It even takes mortgage-backed securities as collateral in exchange for the liquidity. But it is not standard practice. The Fed's intervention was also aimed at stabilising interest rates.
During the 1997 crisis in Thailand, the Financial Institution Development Fund was forced to provide blanket guarantees to bank and finance company deposits. Still, the depositors rushed to withdraw money because they were not confident in the status of ailing finance companies and banks. They withdrew so much money that the finance companies and banks did not have enough to hand back to them because the deposits had been extended to long-term investment. So the FIDF had to inject cash into these ailing companies. In return, the companies and banks had to pledge assets as collateral.
Thai equity investors should not take the ongoing turbulence in the financial markets and the growing loss of confidence in the global banking system for granted. Due to the credit squeeze, international money managers are likely to sell Thai and other Asian stocks to meet payments at home. Although the broad global money supply remains buoyant, there has been a reduction in the cash money markets as a result of tightening lending criteria, cutting of credit lines, and collateral revaluation. Risk aversion has become evident. Asian investors will face ongoing indiscriminate selling pressure as Asian financial assets are liquidated by banks in order to offset losses from illiquid assets such as the sub-prime debt.
Fortunately, the direct impact of the sub-prime debt panic on Thai banks so far is not significant. Thai banks have very small, almost insignificant exposure to the US mortgage-backed securities and CDOs. But nobody is quite sure how it will affect the overall global liquidity and financial system.