Globalisation leads to contagion

Anyone interested in my take on the latest volatility in the financial markets can read my comment in this week’s Fund Strategy (30 July).

Not long ago, any problems in a foreign mortgage market would be of little interest to British investors. The shift to a more global world economy and financial system, where markets have become closely interconnected, has changed all that.

Last week, America’s subprime mortgage problems finally hit global equity markets. After months of jitters in the bond markets, the anxiety infected stocks and markets around the world tumbled.

To understand how “contagion” can pass from one market to another, it is worth examining how the problems have spread from subprime. Although the details are complex, the unfolding of the crisis can at least be outlined in schematic terms.

The origin of the crisis can be seen in the surging American house prices running up to 2005. As a result, lenders lowered their underwriting standards for new loans and increased the proportion of lending to subprime borrowers. The process is discussed more fully in last week’s cover story by Vanessa Drucker.

When the housing bubble burst, the mortgage market was hit. Delinquencies and foreclosures leaped. Rising interest rates are likely to exacerbate the problem.

In earlier times, the difficulties would probably have remained confined to the mortgage market; perhaps hitting the American economy too. But in the more globalised world, it infected the bond markets.

One of the main transmission mechanisms from the mortgage market to bonds are Collateralised Debt Obligations (CDOs). These are essentially mortgage obligations that are bundled and traded in the market. The problems in the mortgage market have hit CDOs, which in turn have hit institutions, including hedge funds, that hold such debt.

Uncertainty about CDOs has increased risk aversion in the bond markets. Spreads between relatively safe forms of debt and risky bonds have widened.

Last week it was the equity markets’ turn to take a hit. The main reason seems to be that until now relatively buoyant bond markets have helped support equities. For example, cheap debt has made it easier for private equity firms to buy company shares. But it appears that the equity markets have realised the days of easy money from bonds could be over.

None of this means globalisation is necessarily bad. On the contrary, the ability to spread risk has many advantages. But the down side is that problems can easily move from one market to another.