http://business.guardian.co.uk/story/0,,2139307,00.htmlAngela Balakrishnan
Wednesday August 1, 2007
Guardian Unlimited
Why are world stock markets in such turmoil?
Billions of pounds have been wiped from the value of world stock markets over the past week, with shares dropping another 2% this morning alone.
The turmoil began in the US late last week but has spread to Europe and Asia. Investors have been dumping shares and a "flight to quality" has seen them switch instead to safer, less volatile investments including US Treasury bonds and UK gilts, and currencies such as the yen.
Why is this happening?
The are several factors but the principal one is the shake-out in the so-called "sub-prime" lending market in the US, where billions of dollars of debt lent during periods of low interest rates to high-risk borrowers have come unstuck now that interest rates have risen.
Many customers are finding themselves unable to meet repayments.
Falling house prices in the US after years of boom have meant many of these sub-prime mortgages are now in trouble.
A number of sub-prime lenders are teetering on the brink of collapse and today's stock market jitters were sparked by news last night that American Home Mortgage Investment Corp, the 10th largest residential mortgage lender in the US, has run out of cash and is likely to go into liquidation.
The company is a mainstream mortgage lender and so investors fear that the financial problems in the US banking sector could be bigger than initially feared.
Why does this matter to the rest of the world?
If the crisis in the US housing market spreads then there could be serious consequences for the US economy - the world's largest.
A sharp slowdown there would have consequences for other economies which export goods and services to the US.
What is happening with "highly leveraged" takeovers?
The loss of confidence in the US housing sector has been exacerbated by a feeling among investors that interest rates in the UK, Europe and possibly even the US, may have further to rise as central banks move to ensure inflation remains low.
As a result, banks are now less willing to lend money to fund highly leveraged deals (bids made with borrowed money) and some highly publicised corporate takeovers have been delayed.
Private equity firms trying to buy Chrysler and Alliance Boots are struggling to raise the $20bn (£9.9bn) of loans needed to fund their deals and a sale by Cadbury Schweppes of its North American drinks business has been postponed.
Shares in companies tipped as bid targets have been falling as prospects of a deal, at least from private equity buyers, look more remote.
How serious are the stock market falls of the past week?
In historical terms, they barely register when compared to the 1987 market crash and the falls suffered in May last year, which saw the FTSE 100 shed 500 points in a period of 10 days.
The falls in the London stock market between 2000 and 2003 after the bursting of the dotcom bubble saw shares lose half their value, seriously damaging the health of UK pension funds.
But analysts warn that things could get much worse.
What does this all mean for economic growth?
If the fall in share prices is sustained then it will make it harder for firms to raise cash from stock markets.
Investment could thus be held back, with a knock-on effect on job prospects and growth. If the falls in the stock markets are prolonged, there could be a recession. At the moment analysts say this is unlikely, but warn that growth in the UK could fall sharply, knocking consumer confidence.
And the housing market here?
Rattled stock markets could make lenders here more cautious about borrowers in the sub-prime area. While this market is only 10% of new borrowing in the UK, compared to 25% in the US, a credit squeeze could see housing demand fall. This would have a knock-on effect on house prices and, in turn, depress consumer confidence.
What does it mean to shareholders?
A fall in stock markets means the value of investments has fallen and so shareholders in effect are a little poorer.
In the US, around a half of all households own stocks or shares and in the UK this is around a quarter.
However, most people do not tend to watch the day-to-day value of their investments instead looking at them over the long term. So any falls over a few days, week or even months may not be too worrying in the long haul.
What about pension savers?
Many of the shares that have lost value are owned by pension funds and insurance companies. These shares make up a part of the portfolio used to pay people's occupational pensions.
If shares fall, they may have less money to pay future pensions, and employee contributions may have to rise.
The pensions black-hole is already a big problem in both the UK and US as many companies have closed company pension schemes to new employees. Another crisis in the stock markets could lead to more scheme closures and deepen the pensions shortfall.
http://business.guardian.co.uk/story/0,,2139307,00.html
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