Current market turbulance
September 16, 2008
While the market has been familiar with the problems affecting Lehman for some time, the failure of Merrill Lynch to remain independent and the emergence of liquidity problems at AIG have surprised the markets. Markets hate surprises, especially negative ones and stock market falls are an understandable response to this.
At its core the Lehman-Merrill Lynch-AIG financial crisis is about balance sheets. On the way up the credit bubble helped to inflate the values of houses and commercial real estate and mortgage-backed securities based on them. As long as asset prices were rising, investment banks, mortgage finance companies and hedge funds were only too happy to borrow more and more to invest in these assets. As the asset prices rose this was fine and balance sheets appeared healthy.
Unfortunately as the credit crunch has developed the situation has gone into reverse. In simple terms those firms, funds, or individuals that are most heavily leveraged are facing massive problems. Investment banks like Lehman Brothers and Merrill Lynch were at the forefront of the balance sheet boom, but now the assets they bought are declining in value, and lenders have been unwilling to roll over their loans. For Lehman their large holdings of real estate and mortgage backed securities, combined with their massive leverage, has bankrupted the business.
In terms of the future, to be frank I have no idea what may happen over the next few days, but current events have shaken confidence and are likely to lead to a fall in inflation expectations. As a result of this we can expect further significant moves from policy makers with the possibility of aggressive US interest rate cuts starting from tomorrow’s Federal Reserve meeting. If the US does cut rates it is likely that the Bank of England and the ECB will follow, in part to avoid currency overvaluation and to reduce the effects of any recessionary pressures.
Investors are looking for the moment that marks the turning point - the beginning of the end of the crisis. Unfortunately nobody rings a bell at the bottom of the market and indeed it is too early to tell if these latest events represent that stage, but clearly it is possible.
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