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Published on August 17, 2007

The Stock Exchange of Thailand (SET) has not been spared, having faced selling pressure over the past week. Yesterday alone, the SET index shed almost 4-per cent due to selling pressure from foreign institutional investors, who needed the cash to redeem funds or alleviate the tight credit situation back home.

How could events in the US sub-prime mortgage market shock the world and result in a global credit squeeze?

It started off with easy credit and a low-interest-rate environment several years back. Financial institutions or mortgage companies went after homebuyers like crazy, giving them easy loans to purchase homes. Buyers with murky credit histories also found cash being placed into their hands. Never mind the payback time: if these homebuyers could not make their instalment payments, the financial institutions or mortgage companies could foreclose on the properties and sell them to other buyers. By the way, US home prices would continue to rise, so that at the end of the day nobody would get hurt.

Then there were a bunch of smart US investment bankers, who repackaged these risky sub-prime loans into mortgage-backed securities and resold them to not only US investors but also to investors around the world. That was not the end of the story. Investment bankers also bundled the sub-prime mortgage-backed securities with other financial instruments and called them collateralised debt obligations (CDOs). The CDOs, bundled together with high and poor quality products, were also sold worldwide, with European financial institutions and insurance companies having the largest exposure. Buyers grabbed the CDOs, which gave out yields of more than 10 per cent, compared to more than 5 per cent for government treasuries.

The problems were accentuated several weeks ago when defaults among sub-prime mortgage borrowers were becoming more apparent. As demand for the US securities or CDOs dried up, the banks and funds were unable to sell and had to mark down the value of their holdings. This has resulted in a chain effect because banks are unwilling to lend money out when uncertain of the credit worthiness of their institutional clients. This has, in turn, spooked global investors and caused credit markets worldwide to tighten.

The US Federal Reserve, the European Central Bank, the Bank of Japan and other central banks have reacted to the credit squeeze by pumping more than US$300 billion (Bt10.2 billion) into money markets to smooth out trading, otherwise global financial systems would collapse. The European Central Bank has faced the greatest trouble because of the heavy exposure of European financial institutions and funds to CDOs. The European Central Bank is blood-soaked and has had to pour in the largest chunk of liquidity to save its financial markets.

In the meantime, European financial institutions and funds with exposure to the US mortgage securities and CDOs are losing money in a hurry. The dust has not settled yet. Once the turmoil subsides, we'll see several institutions fold.

Is the US doing enough to calm the financial turmoil? The Fed has not been in much of a hurry to come to the rescue. Some economists even argue that the Fed should not cut interest rates to help out banks and institutions facing the crunch because that would create a moral hazard like the time of the collapse of the hedge fund LTCM in 1998. Instead, the Fed should continue to focus on inflation targeting, or managing its monetary policy to curb inflation at a time when the general economic situation remains intact.

US investment bankers have flooded the world with CDOs. The European and Asian institutions and funds have now learnt another hard lesson. They will never beat out the Americans when it comes to high-risk, high-return financial derivatives.

Thailand is facing the tailspin from this global financial turmoil. Foreign investors, who earlier held about Bt400-500 billion in Thai stocks, are retreating to get cash home to redeem funds. Fortunately, Thai banks have very little exposure to CDOs. They are not yet that sophisticated with their investment portfolios. However, Thai authorities have to stay alert to any ramifications from the global credit squeeze by being prepared to pour in liquidity to keep the local financial system afloat.

Thanong Khanthong

The Nation