My 2 Cents:
4 Reasons to be cautious about the fallout from US credit crunch

          August was a particularly trying month for global investors with equity markets around the world posting record lows for the year. The recent panic sparked by the global credit crisis has triggered the most serious market turbulence since the aftermath of the dotcom mania in 2001-2002. The US Federal Reserve, European Central Bank and other central banks were forced to pump over USD 150 billion into the world’s banking systems to stabilize short-term lending markets in order to calm down jittery investors.

          Many optimists are now hoping that the worst is over, just like the short-lived volatility that started in Shanghai earlier in the year. But this is wishful thinking in my opinion. After several years of continuous bull markets where imprudent lending practices were tolerated, we are likely to witness a long and painful period of correcting the excesses in the world’s credit markets. And it is likely there will be more shocks over the next several months, as global financial institutions come to terms with the dud loans in their portfolios.

What Lies Beneath?

          As default rates in the US subprime markets are coming in fast and thick, problems have graduated from little-known US home builders and mortgage providers to brand name commercial and investment banks, setting off the vicious circle of falling house prices, rising levels of unsold homes and the financial stress from the expected surge in higher interest mortgage resets in 2008. Odds are there will be no early end to these housing sector woes in the US. There are four reasons why investors everywhere should be cautious about the ongoing fallout from the US housing market.

          1 US housing-credit have already spread to other sectors in the economy, particularly the financial institutions. Not only have several hedge funds suffered or failed as a result of their exposure to US mortgage products, but some banks and insurance companies as far afield as Thailand, Australia and Europe have also run up large losses. And this could be just tips of the iceberg, with major titans like Goldman Sachs and Bear Stearns announcing recently that some of their own hedge funds have been badly hit.

          2 Problems in the US housing credit market have also spilled over into the world of “leverage loans,” which have been widely used to finance the global boom in mergers and acquisitions (M&A). While company balance sheets in most countries are, in general, still in quite good shape, this is no longer true for some of them that have been targets of private equity buyouts. As a result, shares in private equity firms such as the newly listed Blackstone Group, have suffered heavily and it looks like there will a significant slow down in the M&A deals that have been pushing up global equity markets to the current levels.

          3 As investors re-price credit risks, meaning, reduce them, it’s likely that banks will have to impose tighter credit standards on borrowers and possibly start pulling out of deals that are already in the pipeline. As credit becomes more expensive, capital spending will slow and companies will have less money to fund share buybacks – a key support for the equity markets. These factors, along with weakening consumer and business confidence, could tip an already stalling US economy into recession.

          4 The financial products fads of recent years such as collateralized debt obligations (CDOs) in mortgage markets and collateralized loan obligations (CLOs) in loan markets are now proving to be opaque, hard to value accurately, illiquid and potentially dangerous to both lenders and borrowers if their real worth has to be accounted for at short notice. In this kind of situation, desperate sellers often have to get rid of the more liquid and tradable assets first, hence the heightened volatility in blue chip stocks in recent weeks.

Is it too early to go bargain hunting?

          All of these developments are representative of a credit cycle in which leverage has been ratcheted up to excessive level. But it does not mean that the current fall out will be disastrous to the global economy. In fact, there are still several positive economic signs such as health GDP growth, low inflation and enormous investment firepower from Asian central banks, particularly China with over USD 1 trillion war chest and petrol dollar flows from the Middle East. But I am still of the opinion that the worst is not yet over. The one safety net is that if credit problems continue to worsen and housing prices in the US keep on falling, central bankers in many countries still have room to cut interest rates in an attempt to stop the markets from seizing up. Whether this is enough to save the day or not, only time will tell. 

          However, like everything else in life, one man’s loss is another man’s gain. Investors who have been savvy and patient may find opportunities to pick up cheap equities when everybody else is losing their shirts. Sectors that are likely to benefit from powerful long-term trends are particularly attractive such as commodities, renewable energy themes and eventually, dare I say it, real estate, when the price is right after all the speculators have been flushed out.