Cooking the Books 1: Turmoil at the Stock Exchange

“FRESH TURMOIL IN EQUITY MARKETS” read the headline of the weekend Financial Times (11/12 August) after a week of dramatic falls in share prices on the world’s stock exchanges. “GROWTH THREATENED BY MARKET TURBULENCE, SAY ECONOMISTS” read the one in the Times the next day, which reported the principal of one hedge fund are saying “Nobody has yet mentioned to me the possibility of a stock market crash and I find that surprising”.

So, what was it all about? Could it really have been a prelude to another 1929 and 1930s slump? Or was it another purely financial crisis hardly affecting the real economy?

Although the turmoil was centred on financial markets, especially stock markets, in most respects its origins lay in the housing sector in the US where financial institutions have been selling “sub-prime” mortgages, i. e. to those with poor credit records and who are therefore more likely to default – and have been. The US housing market bubble – now being paralleled in the UK and elsewhere – has come to an end and mortgage defaults have escalated.

Financial institutions in the US and elsewhere are now coming under pressure because of their exposure in this market but the main issue at present is that no-one knows the extent of the problem, mainly because much of this debt has been packaged together and sold on to financial institutions other than those originally lending the money.

Some hedge funds and other financial instruments that have invested in this debt in the hope of higher than average returns for their investors have got into trouble. In the case of some funds run by BNP Paribas, they have simply been unable to calculate their value because of the current volatility of this sector of the financial markets, leading to even further fear and uncertainty.

The most serious knock-on effect has been a tightening of credit – banks are reluctant to lend money, even to one another. It is this that has been affecting stock markets in particular.

The easy credit that has helped financial merger and acquisition activity the last two or three years (especially by private equity firms) propelled the stock markets of the world upwards. This is because private equity groups, by changing the legal status of the firms they take over from public to private companies, have been taking firms off the stock market and so reducing the supply of shares available as a whole; also, easy credit has helped companies buy back their own shares, to the same effect – reducing the supply of shares and so, in accordance with the law of supply and demand, pushing up share prices.

It is the end of this easy credit and the positive stock market conditions it has promoted that is bothering the financial markets more widely. In truth, after the massive stock market falls of 2000-2003, most stock markets are not over-valued but are being affected by a contagious fear that has spread from the housing sector via the credit markets.

But this is one of the problems with the capitalist market economy – the lack of planning and the instability inherent in the system can have far-reaching and unpredictable consequences. Just how far-reaching only time will tell, but given the underlying problems into the UK housing market alone, this period of market fear may have some way to run yet.