Hedge fund issues could cause economy to slow
Hedge fund issues could cause economy to slowWhile hedge fund failures are typically seen as a Wall Street problem, economists are forecasting that recent hedge fund meltdowns could impact Main Street and may even slow the U.S. economy. Turmoil in credit markets could push up borrowing costs for businesses and consumers and cause a ripple effect.
Hedge fund woes could hit Main StreetUpheaval in credit markets could hit consumer, business borrowing - and slow the economy; risk premiums already rising.
By Chris Isidore, CNNMoney.com senior writer
June 21 2007: 3:21 PM EDT
NEW YORK (CNNMoney.com) --
When Bear Stearns's hedge funds melted down this week because of too big a bet on subprime mortgages, it may have seemed like a Wall Street problem.
But numerous economists said the latest turmoil in the nation's credit markets could spill over to Main Street as well, raising borrowing costs for consumers and businesses alike - and possibly putting the brakes on the surprisingly resilient U.S. economy.
Subprime mortgages, made to home buyers with less than top credit ratings, have been skidding since early this year as delinquencies and foreclosure rates soared. Now problems with those mortgage loans have sparked a big headache for Bear Stearns (Charts, Fortune 500) and the Wall Street firms that lent it money to invest in subprime mortgages, such as Merrill Lynch (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).
But the problems threatening the credit markets could mean far more than just billions in possible losses for those firms. It could push rates higher for corporate debt, which has been relatively cheap even for companies with poor credit ratings.
Even if those companies don't fall behind in their debt payments the way many subprime borrowers have on their mortgages, the investors making money available for those riskier loans are now demanding a much higher premium than they had until just recently.
Deadly ripples threaten subprime funds That could choke off the supply of relatively cheap money that has kept the U.S. economy humming in recent years, putting a dent in everything from business investment to consumer spending.
"That's clearly high on my list of things to worry about," said David Wyss, chief economist at credit-rating agency Standard & Poor's. "I think it's healthy that pricing for risk changes. I think it's too loose now. But the transition could be painful. It depends on how fast it happens."
Wyss doesn't believe that the rise in borrowing costs for most companies will plunge the U.S. economy into recession - and many economists agree with him. They said there's enough underlying strength in the economy to keep it growing. But it will mean slow growth in the second half of this year rather than more normal "trend" growth of 3 percent a year or greater, said John Silvia, chief economist at Wachovia.
"I would think that that as you reprice risk, it will have a negative impact on economic growth going forward," said Silvia. "It will extend the workout in the housing market. And at the margin, they [higher rates] will crimp consumers and their spending."
Others see an even more drastic correction. Peter Schiff, president of Euro Pacific Capital, a brokerage firm specializing in overseas investments, said he had already been expecting a recession in late 2007. Now he believes the recession will come sooner, and hit harder, because of the problems with the Bear Stearns hedge funds.
"This is just another graveyard they can whistle by," he said, referring to Wall Street firms. "Eventually they're going to be overwhelmed. Interest rates are going to rise across the spectrum, and spreads are going to widen considerably."
That widening of the spreads - the difference between what it costs top borrowers and those deemed more risky - has already started. The spread between corporate debt that is not investment grade, popularly known as junk bonds, and a basket of U.S. government bonds was 2.89 percentage points on Thursday, according to Wyss, up from a record low of 2.65 percentage points on May 25.
Wyss said the spread had gotten too narrow and that a correction was likely even without the Bear Stearns problems. A more typical spread is close to four percentage points, and it was as high as 3.85 percentage points as recently as last September.
But he said an event in the credit market such as this week's meltdown typically sends spreads soaring. He noted the rise of roughly one percentage point in just two months in 2005 from a then record low in March following General Motors (Charts, Fortune 500) and Ford Motor (Charts, Fortune 500) debt being cut to junk bond status for the first time.
Full articlehedge funds, economics, capital markets, interest rates, bond yields, valuations, CDO, credit derivatives, derivatives, pooled securitiesLabels: bond yields, capital markets, CDO, credit derivatives, derivatives, economics, hedge funds, interest rates, pooled securities, valuations
Credit-Default Swaps Spur Fastest Derivatives Growth
Derivatives market grows at fastest pace in nine yearsThe Bank for International Settlements said today that the global derivatives market during 2006 rose $15 trillion, the fastest pace in nine years. To beat estimates, Bear Stearns, Deutsche Bank and Morgan Stanley relied on credit derivatives. "Derivatives are now a major contributor to investment bank earnings," said Jerry Del Missier, co-president of Barclays Capital in London.
Credit-Default Swaps Spur Fastest Derivatives GrowthThe global derivatives market grew at the fastest pace in at least nine years during 2006 as the amount of contracts based on bonds more than doubled to $29 trillion, the Bank for International Settlements said today.
Derivatives covering bonds and loans rose by $15 trillion last year, the Basel, Switzerland-based bank said on its Web site. The total amount of over-the-counter contracts whose value is derived from price changes of bonds, currencies, commodities and stocks, or events like interest rates or the weather rose 39.5 percent to $415 trillion, the biggest jump since the BIS began compiling the data.
Morgan Stanley, Bear Stearns Cos. and Deutsche Bank AG depended on credit derivatives to report first-quarter profits that beat analyst forecasts. Federal Reserve Chairman Ben S. Bernanke said last week that the contracts ``increased the resilience'' of financial markets, while warning that they may be exploited by investors to profit from insider trading.
``Derivatives are now a major contributor to investment bank earnings,'' said Jerry Del Missier, co-president of Barclays Capital in London, the biggest underwriter of European bonds last year.
``Credit derivatives will continue their high growth path for a long time yet, and that growth rate will be higher than any other market.''
The actual money at risk through credit derivatives increased 93 percent to $470 billion last year, the BIS said. The amount at stake in the entire derivatives market is $9.7 trillion, according to the BIS, which was formed in 1930 to monitor financial markets and regulate banks.
Salomon Brothers
The market, started by Salomon Brothers Inc. in 1981 when the firm arranged for International Business Machines Corp. and the World Bank to swap debt payments in Swiss francs and German marks for dollar obligations, has become Wall Street's most- profitable activity.
Morgan Stanley, the world's second-biggest securities firm by market value, said a jump in revenue from credit products helped spur a 70 percent increase in first-quarter profit to an all-time high.
Bear Stearns, the fifth-biggest U.S. securities firm, said credit derivatives trading contributed to an 8 percent increase in first-quarter profit.
Deutsche Bank reported record revenue from trading debt and credit derivatives, helping lift first-quarter profit by 30 percent.
Contracts on bonds took off in the 1990s when New York-based JPMorgan Chase & Co. led banks creating credit-default swaps. The contracts allow bond investors to hedge against the risk of a company or country defaulting on interest payments or speculate on its creditworthiness.
Market DeclinesDerivatives helped investors hedge their risks and contained a decline in bond prices during 2005 when the credit ratings on debt of Ford Motor Co. in Dearborn, Michigan, and Detroit-based General Motors Corp. was reduced to below investment grade.
The contracts also limited the fallout from Greenwich, Connecticut-based Amaranth Advisors LLC's record $6.6 billion loss last year and this year's slump in the U.S. subprime mortgage market, said Anshu Jain, head of global markets at Deutsche Bank in London.
``We have been through several market corrections in the past few years and in each case, markets have recovered,'' Jain said in an e-mail. ``In retrospect, people think the market has been characterized by calm, continuous and even benign conditions. Derivatives are a big part of explaining that phenomenon.''
Financial StabilityIn a separate report, a group of central bankers, finance ministries and financial regulators known as the Financial Stability Forum called on hedge funds to improve risk management to prevent shocks to the financial system. The group's Secretariat is based at the BIS.
The Forum's report, dated May 19, said there has been ``some erosion in counterparty discipline recently,'' citing the competition among banks for hedge fund business. The world's more than 9,000 hedge funds move money in and out of markets faster and in larger quantities than mainstream funds, raising concerns about the stability of global markets.
Banks and hedge funds say it's cheaper and easier to use credit-default swaps than buying or selling the underlying securities. Investors who buy the contracts are paid the face value of the underlying debt in exchange for the defaulted notes should the company fail to adhere to debt agreements.
Interest-rate swaps remain the biggest part of the derivatives market, growing 15 percent to $292 trillion, compared with 38-percent growth the previous year, the report said. The contracts allow companies to switch between fixed-rate and floating-rate interest payments.
Growth in the overall derivatives market outpaced the previous record increase of 39.2 percent in 2003.
Foreign-exchange derivatives rose 28 percent to $40.2 billion in 2006. Contracts based on commodities such as gold and oil expanded by 27.7 percent to $6.9 trillion.
The BIS surveyed 62 institutions for its semi-annual report.
The outstanding amounts of derivatives ($ trillion).
End-Dec 2006 End-June 2006 End-Dec 2005
- Interest rates 292 262 212
- Credit 29 20 14
- Equity 7.5 6.8 5.8
- Commodities 6.9 6.4 5.4
- Foreign Exchange 40 38 31
Full ArticleLabels: capital markets, credit derivatives, investment banking
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