Global Economics

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Global Economics
Sub-prime woes, rising inflation A battle of ills
Stuart Green Tel [phone]stuart1.green_at_
hsbcib.com
June 2008
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The key challenges

• Recessionary fears and financial stresses are
  stalking the developed world
• while inflation remains the major concern in the
  emerging world
• The existing monetary order is struggling to
  reconcile these related trends
• and policymakers are facing a long, difficult
  battle of ills between weaker growth and higher
  inflation

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1. The developed world has moved from a condition
of excess to deficient liquidity

• Cheap money Policy rates and emerging markets
• Asset price booms rising collateral and a taste
  for the exotic
• Financial innovation - originate to distribute
  model and credit quality
• Fear and loathing - MBS losses and banking
  dislocation

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2. Policy rates fell to unusually low levels
Source Bloomberg, and HSBC
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3. Massive increase in emerging market central
bank foreign exchange reserve holdings
Source Bloomberg, and HSBC
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4. most of which passed into US Treasuries,
displacing other investors

Note red lines indicate end-year consensus
forecasts made at the beginning of each
year.Source Thomson Financial Datastream
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5. and encouraging lending elsewhere
Source Thomson Financial Datastream
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6. Excess liquidity made housing expensive
Source Thomson Financial Datastream
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7. and created a taste for the exotic
Source Thomson Financial Datastream, HSBC
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8. All the ingredients pointed to a boom

• Those involved in securitisation faced rising
  demand on both sides of their business model
• Displaced investors, facing unhelpful
  demographics, sought yield enhancement at
  seemingly no additional risk
• Households looked to maximise their loan
  consideration
• Affordability constraints became increasingly
  binding
• Households grew complacent on house
  price/interest rate risk

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9. Surge in securitisation was focused in
mortgages
Source Thomson Financial Datastream, Federal
Reserve
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10. and securitisation helped sustain the
housing boom
Source Thomson Financial Datastream, Federal
Reserve
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11. The role of securitisation From hero to
villain?

• Theoretically, securitisation can help reduce
  risks and boost efficiency of capital allocation
• Helps institutions manage interest rate and
  duration risk
• Makes availability of finance less dependent
  upon local economy
• Disperses risk across the financial markets and
  according to risk appetite
• BUT, key question is whether the originate to
  distribute model, and the resulting boom in
  mortgage securitisation, encouraged looser
  lending standards and impacted credit quality

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12. Effect of securitisation is increasingly
apparent

• Recent IMF working paper looks at US prime and
  sub-prime mortgage lending decisions between 2000
  and 2006
• the study concentrates upon loan denial rates
• it controls for factors such as income growth,
  LTV ratios and other general economic factors
• residuals are then regressed against factors
  such as competition amongst lenders, level of
  lending activity and whether the mortgage
  originated is to be held by lender or sold for
  securitisation
• Credit booms and lending standards Evidence
  from the sub-prime mortgage market, April 2008

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13. and the evidence suggests there is a case to
answer

• Overall, the evidence suggests that growth of
  sub-prime lending and rise in securitisation led
  to reduced lending standards
• increase in sub-prime activity lowered denial
  rates
• Fed policy had seemingly little impact on lender
  behaviour
• loan sales and loan denial rates linked,
  especially for sub-prime

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14. Credit quality has proved the key casualty in
recent years
Source Bank for International Settlements
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15. generating uncertainty over the extent of
sub-prime losses
Source Bank for International Settlements
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16. Bank failures typically take a long time to
fix
Source Thomson Financial Datastream, Haver
Analytics
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17. but this is not just a US story. Strong
purchases of MBS by foreign investors has led to
contagion
Note Data expressed as a four quarter moving
average at an annual rateSource Thomson
Financial Datastream
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18. with the UK and Europe seemingly most exposed

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19. Euro-zone bank lending standards are being
tightened sharply
Source ECB bank lending survey
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20. with the housing market a growing concern
Source ECB bank lending survey
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21. Economic risk could be the next big factor
for conditions in the Euro-zone
Source Reuters
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22. but exporters, particularly in Germany, have
so far coped well with the record euro
Source Thomson Financial Datastream, and HSBC
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23. reflecting strong demand from emerging
markets
Source Thomson Financial Datastream
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24. Indeed, the US would have faded further in
the absence of emerging market demand
Source Thomson Financial Datastream
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24. where inflation, rather than growth, remains
the bigger concern
Source Thomson Financial Datastream
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25. Inflationary pressures are deep-rooted, and
will not easily disappear
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26. Various options available to EM policymakers,
but each have their shortcomings

• A modest, one-off appreciation this may lack
  credibility and attract further capital inflows
• A tightening of fiscal policy likely rise in
  current account surpluses will aggravate G7
• Do nothing risks encouraging a deep-rooted
  inflation problem, particularly if other EM
  countries follow suit

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27. Exchange rate appreciation hasnt yet helped
China control inflation
Source Thomson Financial Datastream
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28. and the case of Brazil shows there are no
easy answers
Source Thomson Financial Datastream, HSBC
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29. Price leadership in commodity markets looks
to be shifting eastwards
Source HSBC
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30. reflecting the shifting balance of global
growth
Source World Bank, HSBC
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31. and strong demand will likely persist over
the longer-term
Source HSBC
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32. Still, disagreement remains over cause of
rising commodities

• Markets remain unwilling to accept the
  de-coupling argument, and the reduced role of the
  United States as the global price-setter
• Three major alternative explanations have been
  forwarded
• A weaker dollar and the translation effect
• Increased short-term speculative activity within
  commodity markets
• Flow of capital into commodity markets for
  longer-term investment purposes

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33. but the boom has now reached abnormal
proportions
Source IMF
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34. and with volatility likely to prove
persistent
Source USDA
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35. inflation-targeting central banks now face
some tough decisions
Source Thomson Financial Datastream, Eurostat,
HSBC
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36. Conclusions

• The transatlantic economies the US, UK and
  parts of the eurozone are most at risk as a
  result of deficient liquidity.
• The US housing market is already very weak and
  the UK housing market is softening
• but the problems arent confined to borrowers.
• Global lenders are also at risk, and those facing
  the biggest problems are those in the US and
  across Europe who purchased mortgage backed
  securities.
• Banking behaviour is changing, with lending
  standards tightening sharply.
• The originate to distribute model will likely
  be a target for regulation.
• Rampant commodity prices will place growing
  strains on current monetary order
• with central banks in BOTH emerging and
  developed economies facing difficult decisions.

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Summary of Economic Forecasts
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37. GDP Inflation Americas and Europe

3.1

1.2

0.5

2.3

2.3

3.3

2.1

Norway

2.5

3.5

3.0

2.3

2.3

0.7

3.5

2.4

Sweden

4.5

2.8

2.6

2.1

1.4

2.2

3
.0

2.3

Switzerland

3.2

3.1

2.5

1.1

1.1

0.7

1.9

1.0


Note Global and regional aggregates calculated
using chain nominal GDP (USD) weights. Source
HSBC

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38. GDP Inflation EMEA and Asia/Pacific
Note Calendar year except for which is based
upon Egyptian fiscal year (July-June) Global and
regional aggregates calculated using chain
nominal GDP (USD) weights. Source HSBC
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39. Policy rates
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40. Long Rates
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41. Exchange Rates vs USD Americas, Europe
EMEA
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42. Exchange Rates vs USD Asia/Pacific
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Global Economics Team
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Research
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Disclosure appendix
The following analyst(s), who is (are) primarily
responsible for this report, certifies(y) that
the opinion(s) on the subject security(ies) or
issuer(s) and any other views or forecasts
expressed herein accurately reflect their
personal view(s) and that no part of their
compensation was, is or will be directly or
indirectly related to the specific
recommendation(s) or views contained in this
research report Stuart Green Stephen
King This report is designed for, and should
only be utilised by, institutional investors.
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2008. All market data included in this report are
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