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Sunday, September 02, 2007

Tribune article on financial markets

Tribune last month published an article from me on the current turbulence hitting financial markets:

Winston Churchill wrote that in 1929 under his New York bedroom, where he was staying on a speaking tour, “a gentleman cast himself down fifteen storeys and was dashed to pieces, causing a wild commotion and the arrival of the fire brigade.” The cause was attributed to events of the previous day, Tuesday 29th October, known as ‘Black Tuesday’ when shares on the Wall Street stock market plummeted in value. Churchill himself lost over £10,000 in 1920s prices. That evening he was guest of honour at a dinner with many business guests – in a burst of dark humour a guest proposed a toast to “friends and former millionaires”. On the Wednesday Churchill visited the dealing floor of the New York Stock Exchange. He found the scene surprisingly calm but the dealers were “like a slow motion picture of a disturbed ant heap, offering to each other enormous blocks of securities at a third of their old prices…” That was only the beginning of a period of steep falls in share prices.

Almost eighty years later, the recent falls in stock markets across the world provide occasion for us to dust off such stories of previous crashes and financial disasters. It is unlikely any of our political leaders today will be having such a direct experience of stock market panic. Thoughts also turn to 1998, when the hedge fund Long Term Capital Management (LTCM) became a financial black hole when Russia defaulted on its debt. The US Federal Reserve had to organise a bail out and cut interest rates. “Is history repeating or is it different this time?” is the question we are asking across dealing floors in the City and abroad.

Prices of financial securities have been turbulent since the end of July. Towards the end of last week the turbulence increased. Banks became suspicious of lending to each other, prompting central banks to supply cheaper finance to money markets. On one day the FTSE 100 fell over 3.7% as markets sought to adjust to new realities. This completed a fall of over 10% from a high, qualifying as a ‘correction’. A question that might be asked in political circles is what significance these events might have for economic policy, including interest rates.

Markets are reacting to problems in the US sub-prime (higher risk) mortgage market. People on low incomes were offered attractive mortgage packages so they could buy their own homes. Unfortunately, some institutions were too eager to lend and many loans had high interest clauses in the small print with the result that borrowers have been defaulting on their mortgages and sub prime lenders have been getting into difficulties. These mortgages had been repackaged into bonds and sold to financial institutions. At the same time, investment banks have been selling insurance against bonds defaulting; you can buy a bond and buy insurance to compensate you in case the underlying company or assets defaulted. Indeed, you do not have to buy the bond but can just trade the insurance.

Suddenly, as confidence in the sub prime sector dropped, hedge funds and others found they could not accurately price the bonds and other securities in their portfolios. On 9 August, the French bank BNP Paribas announced it had suspended three of its funds because it could not get accurate prices. This sense that the market prices could be some way below last published prices acted as an injection of fear into markets, which has spread to markets around the world. The private equity funds that were questioned by the Treasury Select Committee a few weeks ago had helped buoy shares because of speculation about new bids for companies. Now it is harder for them to borrow cheaply, making some bids less likely. Market participants are all over re-evaluating their measures of risk.

The global economy however remains healthy, according to the IMF. In the UK, the latest Bank of England Inflation Report indicated that interest rates would probably have to rise to 6% to reduce inflation to the target level over two years, but the outlook for inflation (down) and growth (strong) in the next few months was positive.

At times like these, there is great temptation to for leaders to intervene with some public announcement. This temptation should be approached with care. President Bush’s belated expression of empathy for those who have lost homes due to mis-selling of mortgages is unlikely to have endeared him much to victims who have lost almost everything. The sub prime disaster shows what happens when markets, which can be highly useful tools for good, are not regulated sufficiently. Government ministers should be confident while cool as cucumbers.

Stock markets will always gyrate as prices factor in the latest information, as well as greed and fear at times. Government policy has to continue to focus on economic stability and an investment orientated environment.

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