interest rates and the global credit crunch
30 November 2007

Interest rates are high in South Africa and may get worse. Unfortunately, there are strong indications that global credit markets are going to continue experiencing serious problems. We may be forced to pay even higher interest rates in the future, not only because of inflationary pressures, but also because of a continued global credit crunch.

Recent reductions in interest rates and the billions of dollars and euros pumped into credit markets by US and European central banks have had only a short-term impact. The US stock markets improved for a short while when people thought that the effects of the subprime collapse had quickly dissipated. However, more recent disappointing stock market performance indicates that credit market conditions are still tight and that more pain is expected in the future. The subprime collapse is not over. Further, the craziness that consumed global credit markets over the past few years was not in housing markets only. South Africa seems relatively untouched by the subprime crisis at present, but we may be in for unpleasant surprises when other problems related to huge growth in the global structured-finance industry come home to roost.

Structured finance and securitisation of debt were supposed to stabilise global financial markets. Banks could package and sell their loans in secondary markets. It allowed banks to clear loans off their books and create more debt. Unfortunately, many banks have moved out of their traditional business, where they assess the risk of borrowers and monitor loans and repayments. They now profit from earning huge fees on structured- finance deals. The incentive for banks to rigorously assess the creditworthiness of borrowers is not that strong because their profits are related to the repayments of loans to a lesser degree.

Financial institutions camouflage bad debt to make it appear as good debt. The banks have set up subsidiaries that get high credit ratings from the major credit ratings agencies. They use these subsidiaries to develop structured- finance instruments. The pension funds that invest the hard-earned money of their policyholders have regulations and rules that limit the type of investments they can make. Many of them are able to invest only in financial assets with high credit ratings. The high-credit-rated subsidiaries of banks sold these pension funds highly risky financial assets. These financial assets are derived from loans made to individuals and businesses with debt problems but are presented as safe, low-risk financial assets. Of course, they offered relatively high returns on these deceptively packaged financial assets.

Many fund managers who bought this securitised debt were more interested in the higher returns they thought they could earn than in the actual value of the underlying assets and future income streams they were buying. Therefore, we have a global credit market where fund managers chase high returns, banks chase high fees and discredited credit ratings agencies have totally undermined trust in global credit markets.

The panic of the subprime market collapse spread through highly integrated global financial markets like wildfire. Problems in the future may not necessarily be related to low levels of global credit market liquidity.

Future problems could be related to investors having lost confidence in their ability to correctly value financial assets and the low credibility of credit ratings. This uncertainty and lack of trust have left a great many global investors skittish.

Since psychology plays a huge role in financial markets, high levels of skittishness creates a negative atmosphere in global financial markets. We can expect even more panic and herding behaviour than before. Therefore, the growth of structured finance has not stabilised financial markets but, instead, has increased systemic risks in global financial markets.

Edited by: Martin Zhuwakinyu
www.polity.org.za