Shares’ hidden downside

Housing is not the only asset against which banks have been making sub-prime loans – there are shares as well.

After a long period of cheap money and an unusually long and very strong bull market in shares, there is now a large but unknown amount of leverage in the sharemarket and the derivatives connected to it. And shares are now doing what the housing market did – that is, falling.

What might be called the sharemarket’s sub-prime problem has not surfaced and it is earnestly to be hoped it does not, and that the underlying value of the companies produces a floor to the market. But the market is not always rational.

Unlike shares, residential real estate is an illiquid market, so any price contagion is slow moving. Nevertheless rising delinquencies and foreclosures are driving US property values lower and creating a slow-moving, self-reinforcing downward spiral.

In the very liquid sharemarket, this process is much faster and much more dangerous. Margin calls force highly leveraged investors to sell shares, driving prices lower quickly and sparking more margin calls. An avalanche can develop, as happened in October 1987.

The sharemarket is falling around the world as US banks confess to the bad loans they made against housing. But how many bad loans were made against shares? What about the leverage inherent in many sharemarket derivatives such as warrants and CFDs – to what extent will losses on these instruments cause defaults on other loans?

The banks and other lenders must be holding their collective breath right now as this correction in the US reaches 13%, with very little support evident to produce a bottom. In Australia the correction is now 15% and in Japan it is 22%.

The four year bull market since 2003 has brought with it a huge amount of leverage in general, through private equity, infrastructure funds, leveraged property trusts, hedge fund derivative trading, individual margin trading, and so on.

Margin calls are already starting to rise sharply. This morning The Australian Financial Review reported that Macquarie Margin Lending expects to make 300 margin calls today, after making 72 yesterday. Up to yesterday, it says, the bank was making about 60 a day. CommSec, according to the AFR, made 500 margin calls yesterday and Adelaide Bank made 282, beating a record 131 made last Tuesday. Up to then it had been making between 20 and 50 a day.

But while the housing sub-prime problems are now known and measurable because both industry-wide and individual bank exposure and delinquency figures are being pitilessly reported virtually every day, very little is known about leverage in the stock and derivatives markets.

For example, how much money have investment banks lent to investors buying into their own infrastructure funds to boost their fee income? Quite a lot, I would say at a guess.

And in many cases the lenders are not capitalised under international accounting standards (Basel II) rules, and therefore don’t have a lot of buffer if the funds’ prices go south and defaults on the loans rise. This scenario produces a balance sheet double whammy – securities and loans lose value at the same time, reducing the investment bank’s capital base and forcing it to liquidate assets.

None of these things needs to happen as long as liquidity is handled carefully by the central banks (that is, they provide tonnes of it) and the new equity investors of last resort – the sovereign wealth funds – stand ready to mop up assets at greater than receivership prices.

The willingness of sovereign funds like Abu Dhabi, Kuwait, Singapore, Korea and New Jersey (!) to tip money into banks like Citigroup as they write-off housing sub-prime debts is encouraging, but you wonder what will happen if the same banks come back for a second helping as sharemarket loans start going bad. You want more?

The world’s financial system is at a very dangerous point because of the high degree of leverage that remains and which is only half understood.

This article first appeared in BusinessSpectator.