2008 :

Global Markets – 4th quarter 2008 : The credit crisis – how it all began

When the rumblings of the sub prime credit crisis first emerged in August last year, nobody envisaged the extent to which this would unfold and later become the catalyst for a crisis within financial markets and banking systems around the world. A recent article by Kevin Lings [Economist at Stanlib], based on research by Paul Krugman [2008 Nobel Prize winner for economics] and the Institute of International Finance, explains in five steps how the crisis has unfolded. I have summarised portions of the article below:

1. “A housing bubble was created in the mid-2000’s.” House prices rose sharply between 2002 and 2006, fuelled largely by “low interest rates, increased global liquidity, aggressive and innovative marketing of credit facilities, a belief that house prices would continue to move higher forever, the incorrect pricing of risk and a global search for higher yielding financial assets.” It is important to bear in mind that this was not limited to the US, as house prices in many countries rose sharply over this period – well beyond the rise in household income levels. A dangerous cocktail of “growth in house prices coupled with historically low interest rates and low levels of financial regulation fuelled a boom in sub prime mortgage financing.” It is alarming to note that in 2000 sub-prime mortgage backed securities of $56 billion were issued in the United States, rising to some $508 billion just five years later.

2. “The US housing bubble started to unravel in 2006”. By mid 2006, consumer confidence levels had deteriorated sharply. In addition, “higher interest rates, record debt levels that had been built-up over many years, record oil and food prices” all played a role in the bursting of the house price bubble.

3. “The weakness in the US housing market led to a dramatic fall-off in the prices of mortgage backed securities since ultimately the value of these assets are derived from mortgage payments.” Because many of the institutions had taken on too much debt during the preceding years, many were left with insufficient levels of capital. The article reports that from the beginning of 2007 to the end of September 2008 “banks in the US had written off $334 billion, while European banks had lost $229 billion and Asian banks $24 billion.”

4. “For the past year, financial institutions have been trying to reduce their debt by selling assets, including those mortgage-backed securities, but this has simply driven down asset prices, making their financial position even worse. “ Many banks have become reluctant to lend funds between themselves, with some European banks electing to deposit their funds directly with the European Central Bank [ECB], rather than lending these funds out to other banks. This has only served to make the liquidity issue worse. Unfortunately, due to a shortfall in some of the banks current debt to capital ratios they haven’t been in a position to provide credit to their customers.

5. The US was the first to sign up a “bail out” plan [3 October 2008], followed closely by the UK and several countries in the Eurozone. The US plan is entitled “TARP” or US Troubled Asset Relief Program. According to Lings “TARP calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities, over a period of time, thereby providing much needed liquidity to the US banking system. …the government aims to bring relief to the market for the “toxic” mortgage-backed securities actually bidding up the price of these assets relative to the prevailing market prices (which is extremely depressed), but still buying the assets cheaply enough to reflect the risk currently associated with these instruments. The increased liquidity coupled with the increased price would then help to recapitalise the affected banks.”

Never before have we witnessed a co-ordinated economic recovery package of this magnitude, including synchronised interest rate cuts by Central Banks around the globe. Only time will tell just how severe the impact of the credit crisis has been. One thing is for certain, though, and that is banking as we know it will never be the same again.

Source: Kevin Lings, Economist at Stanlib

SOUTH AFRICA

The Prime Lending Rate and the Repo Rate remained at 15.5% and 12%, respectively during the quarter under review. Market commentators are currently divided as to whether the SARB will cut interest rates at their December meeting. While several factors, including the deteriorating economic environment and an improving inflation number, may provide motivation for a rate cut in December, the Rand still remains vulnerable. We expect that rates will be cut in December, but if this doesn’t happen, rate cuts are likely to commence early in the new year. Until recently, rates were expected to remain on hold until at least the second quarter of 2009.

According to the Bureau for Economic Research [BER] 2008 GDP growth is expected to be in the region of 3.3%. In 2009, the BER expect growth to slow further – to 1.9% [the worst GDP growth level since 1998, when GDP growth was recorded at 0.5%], before picking up to 3.6% in 2010.

In September, President Thabo Mbeki was removed from office by the ANC and Mr Kgalema Motlanthe was appointed as Interim President, pending the elections scheduled for 2009. Several ministers tendered their resignations when President Mbeki left office, including Finance Minister Trevor Manuel. These events served to unsettle the market. However, President Motlanthe’s appointment, together with the fact that Trevor Manuel had been retained as Finance Minister, provided a level of comfort. Kgaleme Motlanthe had previously been deputy president of the ANC [2007 – 2008] and Secretary General of the ANC [1997 – 2007].

CPIX inflation peaked at 13.6% during the quarter, before declining to 13%. While this is still well above the upper band of the inflation target [6%], this number is expected to come off sharply going into 2009.

OIL AND GOLD

The oil price declined sharply during the quarter – to $51.25 a barrel, compared to $113.99 at the end of August [and a peak of $147.27 in July]. The decline in the oil price has provided a measure of relief to Central Banks [by enabling them to reduce interest rates], as the high oil price was the main culprit for driving global inflation higher. A consistently lower oil price over time should result in inflation coming down. Factors driving the oil price lower include “fears over lower energy demand and worsening economic prospects”. However, at present there appears to be an excess supply of oil, which could prompt OPEC to reduce output further. The World Energy Outlook for 2008 Report produced by the International Energy Agency indicates that the oil price could well revert back to levels of $100 a barrel. A BBC article summarising the report suggests that “the immediate risk to supply...is not one of a lack of global resources. Instead, it points to a lack of investment where it is needed.”

The gold price declined to $813.40 an ounce from $837.30 an ounce in August. It is interesting to note that, amidst the global market volatility over the quarter, the gold price has been lacklustre. This is very uncharacteristic, as usually in times of market turmoil and uncertainty, investors tend to seek a safe haven – which in the past has been gold.

CONCLUSION

2008 has been an interesting year, but one that we certainly wouldn’t want repeated. Many regions have either slipped into recession or are fighting desperately to hold one off. Since the impact of the credit crisis firmly took hold in September, global market volatility has risen sharply. As I write this report, the full extent of the credit crisis is still uncertain. In addition, the effects of the various “bail out” packages are yet to unfold. We hope that 2009 will be a year in which we will find clarity on these issues. In South Africa, we face what is likely to be a very interesting election year [we will find out whether the new breakaway party “Congress of the People” has muscle] and, of course, we enter the final leg of the pre 2010 Soccer World Cup journey.

This is our last report for 2008 so we would like to take this opportunity to wish you and your family a peaceful and happy festive season. Please take note that our offices will close at 12h30 on Tuesday the 23rd December 2008 and will reopen at 08h00 on Monday the 5th January 2009.