NEW YORK, 13 August 2007 — Investors from the United States to Europe and Asia are facing their first real test of will since the bursting of the Internet stock bubble six years ago.
As losses on US subprime mortgage investments have shown up on bank and fund balance sheets around the world in recent weeks, liquidity in global financial markets began to evaporate prompting a corporate credit squeeze that forced central banks to inject more than $300 billion into the financial system.
“More than a wake-up call, the subprime mortgage market has suffered a psychological blow whose effects probably will extend well past 2007,” Jeffrey Gundlach, chief investment officer at TCW Group in Los Angeles, which manages assets worth $160 billion, said in a letter to clients on Friday.
Stock markets in the US stabilized after losses early Friday, thanks to the biggest cash injection by the US Federal Reserve since the Sept. 11, 2001 attacks.
The Morgan Stanley Capital International All Country World Index, which represents the equity performance of 20-plus countries, including the United States, had seen its market capitalization plunge by $661 billion to $30.9 trillion on Thursday.
But by the end of the week the MSCI world stock index was still down more than 2.0 percent so far for the month, after losing 2.28 percent in July. In emerging markets things are worse, with the MSCI emerging markets index down 6.1 percent so far in August.
Loose US mortgage lending standards, rising interest rates in 2006, and falling house prices, resulted in increasing numbers of less creditworthy US borrowers defaulting on their so-called subprime home mortgages in 2007.
More than 30 mortgage lenders have gone out of business as a result and Federal Reserve chairman, Ben Bernanke, last month said that about $100 billion or about 10 percent of the more than $1 trillion US subprime mortgage market may be affected.
However, many subprime mortgages are packaged into mortgage backed securities and collateralized debt obligations (CDOs), or bundles of securities with differing yields and credit ratings, which are then sold to hedge funds, banks, and pension funds who want to diversify their risks.
Losses on subprime mortgages have been felt by several hedge funds and banks, including two funds managed by investment bank Bear Stearns, Countrywide Financial Corp., the largest US mortgage lender, and even a German bank, IKB which had to be bailed out by a consortium of state-backed German banks.
“In the months ahead, we should expect to see the liquidation of billions more in subprime-related assets by all manner of investors as further waves of downgrades and defaults roll over the market,” Gundlach added.
The potential impact of subprime mortgage market losses on banks’ balance sheets of banks, and on consumer spending power and US economic growth, has seen concerns about credit risk spread to the corporate bond market as well.
Corporate bond market issuance has fallen during the summer and private equity groups seeking to buy Chrysler LLC, the third largest US automaker, and Alliance Boots, the British pharmacy chain, have struggled to raise the finance for the leveraged buyouts.
