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Factors behind the global market volatility financial scene

— PHOTO: AP

THE CRUNCH: The Times Square news ticker displays financial headlines on August 10 in New York. Bank regulators in the U.S., Europe and Asia injected cash into money markets, stoking concerns of a more pronounced liquidity crunch.

It is amazing how expressions such as sub-prime loans, collateralised debt obligations (CDOs) and hedge funds have so quickly become household terms even in India. The fact is that even within the Indian financial sector these were until recently esoteric concepts and practices. Though widely prevalent in the developed markets their impact on domestic markets has at best been indirect.

Sub-prime mortgages refer to the practice of extending home loans to borrowers with relatively low credit standing. For the lenders, the attraction is the higher interest rate they can charge. (The more creditworthy you are the less will be your borrowing cost). For banks and other lenders/investors everywhere there is a trade-off between safety and return.

If borrowers default it is the lenders who should normally pay for the consequences. However, what should essentially be the credit market’s problem has spread across the entire financial sector. This situation has arisen as a direct consequence of the growing linkages between the several sub-sectors. Loan assets seldom remain in the books of the original lender. They are parcelled out into marketable securities and sold to investors who may be big financial institutions or retail investors.

Collateralised debt obligations (CDOs) are complex structured deals that involve many types of underlying assets. When packaged as CDOs, they promise higher returns than similarly rated instruments. Sub-prime mortgages, when sold thus, can become part of CDOs with various types of underlying risks.

Incidentally, international rating agencies too are drawing flak for maintaining investment grade ratings on some of these even when the danger signals became all too visible. Without an investment grade rating some of these complex instruments would not have found buyers among pension funds, university endowments and others, which are mandated to invest only in instruments with the highest rating.

Hedge funds have a role in the ongoing crisis. Typically these are investment funds open only to a small group of well-heeled investors from whom they charge a performance fee. The other defining characteristics are the complex investment strategies they follow and the fact that they have minimal regulation. It is believed that some of these hedge funds have been the main buyers of the sub-prime mortgage securities. Mainline banks have funded the hedge funds just as they financed the mortgages in the first place.

In any case, hedge funds having large exposures on sub-prime mortgages are the first to go under. The problem has spread from the U.S. to Europe and is likely to spread to Asian and other markets. For emerging markets like India, it is the role of FIIs that will come under scrutiny. They may reassess their risks and emerging markets as being too risky.

Equally likely, the sub-prime mess, because of the serious liquidity problems it has caused in the U.S. and Europe, will curtail FII activity at least temporarily.

The fact that the U.S. Federal Reserve, the European Central Bank and the Bank of Japan have been injecting large amounts of liquidity to shore up the financial sector shows that the problem is no more one of credit markets or stock markets alone. It also shows that for good or bad, globalisation has taken hold in the financial markets. It may not be possible to check the spread of the contagion.

C. R. L. NARASIMHAN

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