* Global economy: More Room to Fall


Richard Moore

"...the problem now is a more serious one -- a credit crisis in which commercial
banks, investment banks, insurance companies and hedge funds all around the 
world are being forced to write off billions of dollars from American subprime 
mortgages and more exotic securities. "


More Room to Fall
Steven Pearlstein
Tuesday, January 22, 2008; A01

With the explosive growth in developing countries such as China and India, and a
modest revival of business in Europe, economists have begun to suggest that the 
global economy is no longer so reliant on the United States.

But judging from yesterday's global stock market meltdown, all this talk of 
"decoupling" may have been a bit premature. For though it may no longer be true 
that a healthy U.S. economy can single-handedly keep the global economy humming,
it still looks to be a necessary ingredient to global prosperity.

As markets open this morning, investors will be desperate for some signal from 
economic policymakers that they share their concern about the global impact of a
U.S. recession. Trading in U.S. stock futures yesterday suggested that the Dow 
Jones industrial average would fall more than 500 points at the opening bell, 
while in Tokyo this morning, early trading put the Nikkei average down almost 4 
percent. Those developments increased the possibility that the Federal Reserve, 
European Central Bank, Bank of England and Bank of Canada might respond with a 
coordinated cut in interest rates.

Central bankers still have real concerns about too-high inflation and the 
appearance that they are being railroaded by investors demanding a return to the
days of cheap money. But they may conclude that the greater danger lies in a 
disorderly unwinding of the global credit bubble that could spiral out of 

Moreover, in yesterday's stampede out of stocks, investors sought refuge in the 
safety of government bonds, which had the effect of driving down interest rates.
A rate cut would merely confirm what the markets have already concluded and the 
quiet criticism that the central banks have been "behind the curve."

During the financial market disturbance last summer, economic policymakers were 
mostly concerned about liquidity -- the availability of short-term money as 
banks husband their cash rather than lend to one another. But after aggressive 
efforts by the central banks to make hundreds of billions of dollars available 
to banks on easy terms, the liquidity crisis has largely abated.

The problem now is a more serious one -- a credit crisis in which commercial 
banks, investment banks, insurance companies and hedge funds all around the 
world are being forced to write off billions of dollars from American subprime 
mortgages and more exotic securities. The stronger ones have enough capital, or 
can raise it, so that their viability is not jeopardized by these losses. But if
even a few of the weaker ones collapse and are unable to repay loans or make 
good on their commitments, it would have a domino effect that could threaten 
still more institutions and trigger another wave of panicked selling.

It is those considerations, as much as a sudden realization over the weekend 
that the U.S. economy was tipping into recession, that drove yesterday's 
sell-off. Leading the way down were shares of big banks and insurance companies,
which fell 6 to 10 percent.

While most of the big U.S. financial institutions have acknowledged major 
write-offs, most European banks have not, and rumors of what's in store have 
just begun.

In Germany, where the DAX index fell by more than 7 percent, Hypo Real Estate 
Holding, a relatively obscure lender, shocked markets last week with news that 
it had lost $570 million on its holdings of collateralized debt obligations. Its
shares fell 33 percent. Yesterday, WestLB, Germany's third-biggest lender, said 
it would post a $1.45 billion loss after suffering trading losses on subprime 
mortgage securities.

Here in the United States, the spotlight is on a group of firms that traded 
heavily in what are called credit default swaps -- contracts that, in effect, 
offer to insure corporate bonds, takeover loans and asset-backed securities 
against default. The buyers of these insurance contracts included banks, pension
funds, hedge funds and investment houses that used the swaps to hedge their bets
or construct elaborate, computer-driven trading strategies. Now, the prospect 
that one or more of the insurers may not be able to make good on the insurance 
has rattled their customers and their lenders, who in some cases are one and the

One of those insurers, ACA, is effectively under the receivership of Maryland's 
insurance commissioner after losing more than $1 billion in the third quarter 
and seeing its credit rating drop from AAA to CCC in a single move. Merrill 
Lynch has been forced to write down $1.9 billion to reflect the likelihood of an
ACA default, while the Canadian Imperial Bank of Commerce said it would have to 
issue $2.75 billion in additional stock to offset losses it thought it had 
insured against with ACA.

Over the weekend, ACA reached a standstill agreement with creditors and 
counterparties who agreed to give it 30 days to raise additional capital or 
unwind its $60 billion in credit default swaps.

Also facing possible ratings downgrades -- and with that, the increased 
possibility of default-- are ACA's largest rivals, MBIA and Ambac. Together, 
those firms insure more than $2 trillion in loans, bonds and other securities. 
Because the credit-default-swaps market is almost completely unregulated, it's 
anyone's guess who is at the other end of those swaps.

Although most of the focus has been on the unwinding of the credit bubble here 
in the United States, there are problems with bubbles in other parts of the 
world. Those, too, played a role in yesterday's stock market rout.

In India, for example, demand for shares has been so frenzied that last week's 
initial public offering by Reliance Power had 10 investors clamoring for each 
share that was offered. Not surprisingly, Reliance was one of the biggest losers
in yesterday's rout as selling shaved 7.4 percent from the Bombay Stock 
Exchange's benchmark index of 30 companies.

In China, where demand for shares is so brisk that the Shanghai stock index has 
more than doubled in each of the past two years, officials recently concluded 
that one way to cool things down was to increase the supply of shares being 
traded. It may have been no coincidence, then, that yesterday's 5.14 percent 
plunge came on the same day that three major share offerings were announced, 
including $20 billion by Pinan, the insurer.

Stock markets in Russia and Brazil too were hit hard yesterday, each falling by 
about 7 percent.

This kind of contagion is rarely a one-off event. Indeed, in Europe and Japan, 
yesterday's rout was merely an acceleration of a sell-off that began months ago.
It's unlikely that the bottom has been reached.

As Bill Conway, a founder of the Carlyle Group and the investment guru of the 
private-equity firm, told The Post's Thomas Heath last week: "We are nearer the 
beginning than we are the end . . . The economy is going to be relatively 
weaker, at least for another year, than it has been the last five years. There 
are very significant problems ahead."

Steven Pearlstein can be reached •••@••.•••.

© 2008 The Washington Post Company

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