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-- Increased Uncertainties about the Economic and Financial Environment, and the Turmoil in Global Financial Markets
-- Developments in Domestic Financial Markets in the First Half of 2008: "Linkage with Global Financial Markets" and "Relative Stability"
September 22, 2008
Bank of Japan
Financial Markets Department
Global financial markets have been in turmoil, triggered by the U.S. subprime mortgage problem. Repricing of risks that originated from securitized products backed by subprime mortgages has spread to overall securitization markets. As of summer 2007, when the subprime problem emerged, the quality of underlying assets for securitized products other than subprime mortgages had not deteriorated notably. The repricing of risks in the second half of 2007 could be considered as a corrective reversal of the lax risk evaluation, stemming from the information asymmetry inherent in the originate-and-distribute model. Since the start of 2008, however, not only subprime mortgages, but also various underlying assets of securitized products, such as corporate loans, consumer loans, and commercial mortgages, began to deteriorate, as the impact of a U.S. economic slowdown gradually spread. This heightened downward pressure on prices of securitized products.
Amid the continued decline in prices of securitized products, transactions dwindled and market liquidity contracted. As a result, financial institutions that had made profits by adopting the originate-and-distribute model with sufficient market liquidity were forced not only to incur mark-to-market losses on securitized products, but also to reintermediate risks. This resulted in an involuntary expansion of their balance sheets, and downward pressure on their capital adequacy. Banks then further tightened their credit standards, and this began to exert negative pressure on the real economy.
As the negative feedback loop between the financial sector and the real economy became stronger in the United States, uncertainties about the economic and financial environment increased, leading to a decrease in risk appetite of market participants, i.e., the widespread reduction of overall holdings of risk assets. Market participants' concerns were fanned by the difficulty in forecasting how far the negative feedback effect would spread and how long it would continue; for example, to what extent the decline in housing prices would expand, and to what extent the financial condition of banks and the household sector would deteriorate. This heightened instability in the markets and made investors more cautious about investing in risk assets. Reflecting the decline in investors' risk appetite, market liquidity declined considerably not only for securitized products, but also for financial assets overall. Because a decrease in market liquidity leads to an elevated risk of price volatility, investors with reduced risk appetite do not buy risk assets, unless a sufficiently high risk premium is paid to them. This means large price discounts may be needed to persuade investors to buy assets with impaired market liquidity. Market contacts suggested that prices of some securitized products had fallen below the level justified by the deterioration in underlying assets. As such, the smooth functioning of markets was impaired, and the price discovery mechanism weakened.
Banks that had to hold assets with low market liquidity increased their demand for raising funds through the money markets to finance the involuntary expansion of their balance sheets. At the same time, in order to secure funds, they were forced to sell securities, which had been considered relatively liquid, such as municipal bonds and agency residential mortgage-backed securities (RMBSs) issued by government-sponsored enterprises (GSEs). As a result, financial institutions faced funding liquidity constraints through mid-March, against the background of the decline in market liquidity due to selling pressure on assets that had been considered liquid and deterioration in the functioning of the repo market, where such securities were used as collateral. Amid a mutually feeding downward spiral in market liquidity and funding liquidity, business came to a standstill at Bear Stearns, a major U.S. investment bank.
As a result of impaired functioning of secured money markets, concerns heightened about the functioning of the two intermediary channels of the U.S. financial system, namely, the securities markets and the banking sector. To address the heightened concerns about financial system stability, the Federal Reserve and other central banks in major countries took a series of liquidity provision measures from mid-March to early May, while many major financial institutions in the United States and Europe strengthened their capital base.
The series of measures staved off a "market run," i.e., herded panic selling of assets by market participants, and thus, concerns about financial system stability and the overly pessimistic views about the U.S. economy abated through mid-May.
However, financial markets remained unstable, amid the continued negative feedback loop between the real economy and financial markets. After mid-May, concerns about the deterioration in financial institutions' earnings resurged, against the background of concerns about an increase in nonperforming assets, due to an economic downturn and a persistent decline in housing prices. This led to a plunge in stock prices. Prices of securitized products also declined further, against the backdrop of the view that financial institutions' increasing difficulties in raising capital would apply even greater selling pressure on their assets. In addition, market concerns over the financial condition of monolines and GSEs, which function as part of the market infrastructure, reemerged, further heightening the instability in markets.
These unstable conditions in the markets were aggravated by heightened concerns about inflation. Since mid-May, inflationary concerns had increased, against the background of continued rise in commodity prices, such as a surge in crude oil and grain prices. This increased uncertainties about the future steering of monetary policy and the macroeconomic environment, and hence reduced market participants' risk appetite further. As uncertainties about financial and economic conditions increased with the rise in crude oil prices, earnings prospects deteriorated not only for the financial sector, but also for a wide range of industrial sectors in the United States, leading to declines in stock prices. Additionally, in emerging economies with a high external dependence on energy, the fragility of the economies became evident with a decline in both stock prices and currencies, as concerns heightened over higher inflation rates, and/or a notable deterioration in external and fiscal balances.
Investment inflows into the commodity markets continued to increase, and hence market liquidity followed an upward trend. In addition to speculators searching for yield, long-term investors, such as pension funds with their aim of diversifying investments, have increased significantly. A driving force that attracted investors into the market was the enhancement of market infrastructure, including investment channels, such as commodity indices and exchange traded funds (ETFs). Amid the recent upward trend of commodity prices, however, the outlook for commodity prices has become increasingly uncertain for both sides: rise or fall. If commodity prices fluctuate significantly in the future, there is a possibility that other financial markets will be affected considerably, as commodity futures have come to play a significant role as financial investment instruments.
The effects of turmoil in global financial markets spread to Japanese financial markets through a portfolio rebalancing by overseas investors and financial institutions. The effects were most pronounced in medium- and long-term fixed income markets and credit default swap (CDS) markets, where the trading share of overseas investors had increased in recent years. In Japan's medium- to long-term fixed income markets, such as Japanese government bond (JGB) markets, prices fluctuated significantly in mid-March, as hedge funds were forced to unwind (i.e., deleverage) their positions, due to funding liquidity constraints. Not only overseas investors, such as hedge funds, reduced their risk-taking ability, but also securities companies, particularly ones that restrained the expansion of risk assets, faced involuntary accumulation of inventories and hence became less active in their market-making activities. This led to the decline in market liquidity in JGB markets. Furthermore, the impact from concerns about global inflation spread to Japan's markets, and this caused long-term interest rates to rise sharply and remain volatile under low market liquidity. Investors' risk appetite declined and they became cautious in investing in assets, whose price volatility was high. This was one factor that had slowed the recovery in market liquidity in JGB markets.
In CDS markets in Japan, CDS premiums widened sharply through mid-March, mainly led by risk reduction and arbitrage transactions by overseas investors. Domestic investors followed these movements and adjusted their positions, inducing market liquidity in CDS markets to shrink rapidly, and accelerating the increase in CDS premiums.
Meanwhile, although stock markets in Japan were also heavily influenced by the activities of overseas investors, Japanese stock prices remained firm relative to U.S. and European stock prices since mid-March, partly supported by the yen depreciation, due to the rise in U.S. interest rates.
Due to the tightening of supply-and-demand conditions in U.S. and European money markets, Japan's money markets remained nervous, as interbank rates were under upward pressure. However, the uncollateralized overnight call rate was stable at around the Bank of Japan's policy rate target of 0.5 percent. Taken as a whole, the turmoil in U.S. and European money markets had only a limited impact on Japan's money markets in the first half of 2008.
Under relatively stable conditions of Japan's money markets, banks in foreign countries (including overseas branches of Japanese banks) increased borrowing funds from banks in Japan (including Japanese banks and Tokyo branches of foreign banks). These funds were then converted into U.S. dollars via foreign exchange (FX) swaps. In addition, the relative stability of interest rates and investors' demand in the Japanese markets contributed not only to the increase in the amount of corporate bonds issued by domestic corporations, but also the increase in the amount of yen-denominated bonds (such as samurai bonds and nonresidents' Euroyen bonds) issued by overseas financial institutions and corporations.
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Financial Markets Department, Bank of Japan
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