Global stock meltdown - nearer the beginning than the end?

This kind of contagion is rarely a one-off event

By STEVEN PEARLSTEIN
WASHINGTON - With the explosive growth in developing countries such as China and India, and a modest revival of business in Europe, economists had begun to suggest that the global economy was no longer so reliant on the United States. But judging from this week's global stock market meltdown, all this talk of "decoupling" may have been a bit premature. For while it may no longer be true that a healthy US economy can single-handedly keep the global economy humming, it still looks to be a necessary ingredient to global prosperity. During the financial market disturbance last summer, economic policy-makers were mostly concerned about liquidity - the availability of short-term money as banks husband their cash rather than lend to one another. But following 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 US economy was tipping into recession, that are driving the selloff. Leading the way down on Monday were shares of big banks and insurance companies, which fell 6 to 10 percent. While most of the big US financial institutions have already acknowledged major write-offs, most European banks have not, and rumors of what's in store have just begun to circulate. In Germany, for example, where the DAX index fell by more than 7 percent on Monday, Hypo Real Estate Holding, a relatively obscure lender, shocked markets last week with news that it had lost $570 million so far on its holdings of collateralized debt obligations. Its shares fell 33 percent. Also Monday, WestLB AG, German's third-biggest lender, said it would post a loss of $1.45 billion 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 their insurance has rattled their customers and their lenders, who in some cases are one and the same. 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 the company 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, are played a role in the 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 Monday. In China, where demand for shares is so brisk that the Shanghai stock index has more than doubled in each of the last 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 Monday's 5.14 percent plunge came on the same day that three major share offerings were announced, including $20 billion by Pinan, the giant insurer. Stock markets in Russia and Brazil have also been frothy, and those too are now being hit hard. This kind of contagion is rarely a one-off event. As Bill Conway, a founder of the Carlyle Group and the investment guru of the private equity firm, said 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." (The Washington Post)