Global Markets Weekly

• The credit crisis shows some similarities to the late 1990s Asian Crisis.
  During the Asian Crisis of the late 1990s, a new word entered the financial market lexicon: contagion. It gained widespread use as financial strains in a few Asian economies spread first to other emerging markets and then to developed markets. As Asian asset prices declined, leveraged investors were forced to sell, so assets which had previously had no fundamental correlation (such as Brazilian and Russian bonds) suddenly became correlated.
• As then, we are now seeing contagion effects in the markets…
  Credit markets are now seeing similar contagion effects. A problem which started a year ago in the lowest-rated portion of the sub-prime mortgage backed security (MBS) market has spread to higher-quality mortgages and even to corporate and consumer credit. The final phase of this contagion is transmission to the real economy.
• …as pressure on banks’ balance sheets causes tighter lending conditions.
  That has already started to happen. Falling asset prices in one sector of the economy (subprime mortgages) have strained banks’ balance sheets, because many hold portfolios of longdated MBSs that are funded on a short-term basis. Credit conditions in the real economy have therefore tightened. This tightening reduces growth and profit expectations, which in turn pushes asset prices down further, and so on.
• The bond insurers’ business model has been called into question.
  Bond insurers find themselves in the middle of this destructive spiral of assetprice deflation. They have a highly leveraged business model which had been assumed to be solvent, because not all the bonds they insure would require capital to support their ratings at the same time. However, that is precisely what has happened. The municipal bond market is critical to what happens next, as a large chunk of bond insurers’ capital reserves is held in municipal bonds insured by other bond insurers.
• The authorities are trying to find a solution…
  Any downgrading of major bond insurers would cause a significant further tightening of credit conditions in the real economy, as banks would have to assign more capital to holding downgraded assets and the pace of forced selling by leveraged players would increase. Not surprisingly, officials are keen to avoid this outcome. A partial solution seems to be emerging which would at least solve the municipal bond problem. This involves splitting off the profitable municipal bond part of bond insurers’ business and allowing them to be recapitalised by an avuncular capitalist, such as Warren Buffet. That would leave all non-municipal issues to be bailed out by investment banks worried about the balance sheet implications of bond insurer downgrades.
• …but banks have little scope to come to the rescue.
  And the clock is ticking. At the end of February, ratings agency Moody’s is due to complete its review of Ambac and MBIA, the largest bond insurers. By then, bond insurers need to find some $15 billion of new capital if they are to keep insuring the $1.2 trillion of bonds on their books. Even that $15 billion is a moving target. As ratings agencies’ assumptions of default rates rise, so does the capital required to cover expected losses. So there’s an open-ended quality to any commitment to bail-out bond insurers’ RMBS books.
• Risk assets will continue to reflect how this crisis plays out.
  We are entering a critical phase in the evolution of the credit crunch. Although it’s hard to see an overall positive outcome, any solution that manages to re-open the municipal bond market must be welcomed. In the near term, the developing pattern of this credit contagion will set the tone for equities and other risky assets.

Indices, Interest rates and Inflation

	Close 15-Feb-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	2,962	0.2	-3.2	-9.2	-9.9
FTSE 100	5,788	0.1	-4.0	-9.0	-10.4
S&P 500	1,350	1.4	-2.2	-7.0	-8.1
Nasdaq Composite	2,322	0.7	-4.0	-11.3	-12.5
DJ Stoxx (Europe)	356	1.1	-7.5	-13.4	-14.2
Nikkei 225	13,623	4.7	-2.5	-11.5	-11.0
Hang Seng	23,148	2.9	-6.5	-16.0	-13.2

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	3.00	3.00	2.50	4.1	18-Mar
UK (Base rate)	5.25	5.25	5.00	2.2	06-Mar
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.2	06-Mar
Japan (Call rate)	0.50	0.50	0.50	0.7	07-Mar

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