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Global Investing: Look Out Below
Thursday, Aug. 16, 2007
By GEORGE MAGNUS

Yes, it has gotten ugly out there. the recent panic sparked by the global credit crisis has triggered the most serious market turbulence since the aftermath of the dotcom mania in 2001 and 2002. The Federal Reserve, European Central Bank and other central banks were forced to pump over $150 billion into the world's banking systems to stabilize short-term lending markets and reassure worried investors.

Many are now hoping the worst is over, but it's probable that a long and painful period of correcting the excesses in the credit markets has only just started. After several boom years, we are likely witnessing the early signs of a protracted decay in the world's credit cycle. Odds are, there will be more shocks over the next several months, and rather than starting to hunt for bargains now, investors would be better advised to remain cautious.

The current trouble can be traced back to disturbances in U.S. mortgage markets, especially in the so-called subprime market sectors, where default rates have been rising sharply. As problems have graduated from little-known U.S. homebuilders and finance companies to brand-name commercial and investment banks, public alarm has escalated. Falling house prices, rising levels of unsold homes and the financial stress from the expected surge in higher-interest mortgage resets mean that there will be no early end to these housing-sector woes.

There are four reasons why investors everywhere should fear the ongoing fallout from the bust in the U.S. housing market.

First, U.S. housing-credit problems have spread to other sectors. Not only have several hedge funds suffered or failed as a result of their exposure to U.S. mortgage products, but some banks and insurance companies as far afield as Australia, Germany and Taiwan have also run up large losses. And they are likely just the beginning, with major firms like Goldman Sachs and Bear Stearns announcing in recent days that some of their own investments have been badly hit.

Second, problems in the U.S. housing-credit-market have also spilled over into the world of "leveraged loans," which have been widely used to finance the global boom in mergers and acquisitions. While company balance sheets in most countries are, in general, still in quite good shape, this is no longer true for some of them, not least for the targets of private-equity buyouts and for private-equity houses themselves. As an example of how quickly the sector has fallen out of favor, shares in the Blackstone Group, a private-equity giant in the U.S., have dropped about 20% since its initial public offering just weeks ago, and the firm has warned of a significant slowdown in deals.

Third, it's likely that commercial and investment banks will have to impose tighter credit standards on borrowers, and possibly even start pulling out of deals that are already under way. As credit becomes more expensive, capital spending will slow and companies will have less money available to fund share buybacks — a key prop for the equity markets. These factors, along with weakening consumer and business confidence, could tip an already stalling U.S. economy into recession.

Fourth, the financial-product fads of recent years — collateralized debt obligations in mortgage markets and collateralized loan obligations in loan markets — which made a lot of money for financial-market participants in the upswing of the credit cycle are now proving to be opaque, hard to value accurately and potentially dangerous to both lenders and borrowers if their real worth has to be accounted for at short notice. There's a knock-on effect to disillusionment with these esoteric products: when investors must raise cash quickly, the more liquid and tradable assets tend to go first.

All of these developments are representative of a credit cycle in which leverage has been ratcheted up to perilous excess. The dénouement of a credit cycle need not end disastrously for investors or the global economy. Even today, we can still point to various economic positives — buoyant global growth, low inflation and enormous investment flows from Asia and the Middle East. But comfort from these forces may be short-lived if credit problems worsen and housing prices keep falling.

This might spur central bankers to lower interest rates in an attempt to maintain the integrity of sound lenders and borrowers and stop the markets from seizing up. Whether this saves the day or is seen as just a symptom of more bad news to come for risky assets will then be the next big issue for investors to interpret. Normally, such moves are seen as bad news. But for investors who have been savvy and patient, such rocky times may offer a fine opportunity to pick up cheap equities, particularly in sectors likely to benefit from powerful long-term trends such as climate change, demographic change and the burgeoning wealth of emerging markets.

George Magnus is senior economic adviser at UBS Investment Bank

http://www.time.com/time/magazine/artic ... 70,00.html