The Credit Crunch explained: Part 2

Crisis guide 2: Part 1 of our feature looked at why the markets got into a mess. Part 2 looks at how contagion could spread and whether the central banks’ rescue packages will work.

Contagion

Is there worse to come?

Possibly. There are two main ways trouble could spread: via hedge funds or banks.

Why hedge funds?

Many hedge funds engage in herding behaviour. A lot are momentum players, following recent trends. They also typically employ lashings of leverage. When markets are rising, this triple cocktail tends to accentuate the upward spiral. When they fall, it can spread trouble.

How come?

When asset prices fall, investors want to take out their capital. The hedge fund then has to sell assets – driving prices down further. The banks that lend them money then ask them to cut their leverage by making a margin call – as they did with Bear Stearns. That forces them to sell yet more assets. Other hedge funds that have been herding into the same trades come under pressure to sell – giving the vicious spiral a further twist. This is why big high-profile “quant” hedge funds like Renaissance Equity Hedge Fund, Goldman Alpha and Man’s AHL fund have had an awful few weeks.

Why should this spread contagion beyond sub-prime?

Hedge funds that need cash quickly don’t sell sub-prime assets because they’d get fire-sale prices. Instead, they sell other assets, like shares.

And the banks?

They are exposed to credit market woes in four main ways: via trading losses on credit instruments they are holding on their own books; via CP back-up loans; via stuck loans to mega LBOs; and through lending to hedge funds. What’s more, investment banks’ equities businesses may suffer if stock markets fall. And their advisory businesses could enter the doldrums if the M&A boom – of which the LBO bubble has been the most vibrant feature – comes to an end.

So how does this bank exposure spread contagion?

If the banks get hit on multiple fronts, they will become more risk averse across the board. They won’t just stop funding LBOs and sub-prime debt. They could become less keen to fund hedge funds, conduits and other special purpose vehicles. That could have a further knock-on effect. Worse, even financially sound companies may start to find it hard to roll over existing debt programmes or raise new finance, forcing businesses to delay investment projects. And banks could become more wary about lending to each other. It was to avert this that central banks flooded the market with liquidity last week.

Central banks ride to the rescue

Did the central banks’ action do the trick?

Well, it certainly managed to drive overnight interest rates down to the official levels. But the fact that the central banks felt they had to inject liquidity two days in a row suggests that the inter-bank market hasn’t yet returned to normality.

What would that take?

Banks aren’t going to start lending to one another again with confidence until they know who is sitting on risky exposures and losses. Rumours are still swirling around markets about how one or more banks could be in trouble. If everybody knew who held the risky positions, there wouldn’t be a problem. Some institutions would report a loss but it would be manageable within their existing capital; others would need a capital injection; yet others would close shop. Everybody else would then go back to business. But until the victims are named, everybody is a suspect.

When will we know who is at risk?

This is the biggest unknown. Banks and other financial institutions don’t disclose detailed risk positions to the market because other market players can then use that information to trade against them.
General comments about how their losses are containable, how their capital positions are strong and how they have no liquidity problems may not reassure sceptics. IKB said it was fine and dandy just weeks before it had to be rescued; BNP Paribas’s chief executive said its exposure to sub-prime was “absolutely negligible” only days before it suspended liquidity in its funds.

So what will the central banks do if confidence doesn’t return?

They can just keep injecting liquidity into the system – day after day.

And banks can borrow as much money as they want, just like that?

It’s not quite so simple. A bank that wants cash has to put up collateral. Central banks obviously don’t want to lose money by lending to a bank that then goes bust. Otherwise, they will have to ask for cash from taxpayers. So normally, they insist on rock-solid paper like government bonds as collateral.

Is that what’s happening?

Not quite. On Friday, the Fed accepted mortgage-backed securities as collateral for the first time. That may have been necessary to avert a liquidity crunch. But Uncle Sam has started to assume some of the banking system’s credit risk.

What will happen next?

The central banks will hope that, after a few more days, confidence returns and they can step out of the picture. Many central bankers think that a short sharp shock is just what’s needed after the loose lending attitudes of recent years. And they’re not too worried because the economic fundamentals are strong. Such a correction is probably the most likely scenario. But there’s a risk that, if more cockroaches crawl out.