Page last updated at 13:31 GMT, Friday, 17 August 2007 14:31 UK

What's behind the market turmoil

Evan Davis, BBC Economics Editor
Analysis
By Evan Davis
Economics editor, BBC News

German trader
Analysts say markets will remain volatile in the near future
It's taken for granted in most of the coverage of the current market troubles that sub-prime problems in the US mortgage market are causing declines in world share prices. But why are they having such a widespread effect?

The best guess is that there are a potential $100bn (50bn) worth of sub-prime mortgage defaults, from less than credit-worthy borrowers, mainly in the US.

So why was $120bn (60bn) wiped off shares in London alone on Thursday?

The reason must be that there are deeper links between sub-prime lending and equities.

Banking sector losses

First, there are some sub-prime losses among banks (or the people to whom they've lent), and banks are listed on the stock markets.

So banks may be worth less than we thought last year.

And it only adds to the problem that we don't know which banks have sub-prime losses, and the banks themselves may not even be sure.

But the second and more important problem for shares is not caused by banks, but hedge funds.

Hedge fund calls

They have typically borrowed money to invest (and they've often borrowed shares and other securities too).

But terms and conditions apply to their loans: lenders tell the hedge funds the debt must not rise above a specified proportion of the total fund.

It would be like your bank telling you that your mortgage can't rise above 90% of the value of your house.

Now what would happen if the value of your house fell?

You would have to find some cash to repay some of the mortgage to ensure it was still not above 90% of the new lower value.

Forced sales

Hedge funds are in that predicament now.

A trader on the floor of the New York Stock Exchange bangs his head as he looks at the Dow Jones index
Predicting whether tougher times are ahead is a tricky business

The losses they've endured on some investments trigger the need to repay cash to prevent their loans breaching their terms.

One way for hedge funds to find cash is to sell shares.

Note that this does not mean the hedge funds are insolvent - they just need cash, and the easiest way to find it is to sell shares, pushing down the prices.

This potentially could be a bit perverse, with the market getting into a vicious circle of falling prices, cash requirements and more falling prices.

If this was the only reason shares were falling, it would probably mean it was a good time to buy them.

But our list of reasons for shares to fall is by no means complete yet.

Lending dries up

The third link is that all kinds of bank lending have been affected by the failure of the sub-prime market.

This is because the whole market in second-hand debt has been paralysed by the sub-prime problems, with traders barely able to value the IOUs in which they have stakes.

This affects the banks, who are sitting on debt they'd like to sell on, but can't. And it affects corporate borrowers, particularly the kind of borrowers who have been using debt to finance highly-leveraged takeovers.

Those takeovers have helped prop up the stock market, and if they now evaporate, the stock market will probably fall.

The real economy

Finally, the tightening of credit conditions in the US housing market and beyond may have real economic effects that depress corporate profits.

Shopper outside Sainsbury's store
The pace of takeovers using borrowed money may slow

The world has been very dependent on US consumer spending.

If that diminishes as the housing market and stock markets dive, then companies are in a pickle, the world over.

It explains why the mining stocks have been among the biggest fallers - if the world economy slows, we won't be needing so much of the stuff they get out of the ground.

The end of the cycle

That's the list of connections between sub-prime and equities.

But there are other things going on in equities too.

Most notably, corporate profits are at a high level; and that might be a sign we are at the peak of a cycle and tougher times are ahead.

We could have surmised this some weeks ago, but other market events might have concentrated minds on it.

Will equities fall further?

Well, I'm afraid the one thing lacking from the arguments here are any numbers.

We might identify the broad issue, but what the traders have to do is to calibrate them and put a price on them all.

What stock markets are going through at the moment means they are struggling to do just that.

MARKET DATA - 11:36 UK

FTSE 100
5429.64up
23.70 0.44%
Dax
5733.05up
19.54 0.34%
Cac 40
3784.02up
14.48 0.38%
Dow Jones
10403.79up
78.53 0.76%
Nasdaq
2273.57up
35.31 1.58%
BBC Global 30
5707.15up
20.65 0.36%
Data delayed by at least 15 minutes


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