06/08/2009 - 00:00

A costly loss of confidence

06/08/2009 - 00:00


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IT was two years ago this month that business media began reporting on events that were starting the shake the foundations of the world's financial markets.

A costly loss of confidence

IT was two years ago this month that business media began reporting on events that were starting the shake the foundations of the world's financial markets.

It was revealed that 35 councils across Australia - including at least 10 in Western Australia - were among major clients of Lehman Brothers-owned firm Grange Securities to have invested in collateralised debt obligations called Federation.

These complex investments had high credit ratings attached, but they did not indicate the real risks involved and were not comparable to corporate or government bonds at the time.

Essentially, the Federation CDO was a bundle of loans and bonds exposed to the US sub-prime mortgage market, offering a fixed annual yield of more than 7 per cent.

CommSec chief equities economist Craig James said bad lending practices led financial institutions to provide loans to borrowers with poor credit histories, but as interest rates started to rise, these sub-prime borrowers started to default.

The mounting mortgage-related losses fuelled more instability in global credit markets, but even by late 2007 Federal Reserve chairman Ben Bernanke said the downturn in the housing market would only be an isolated event.

However, according to Mr James, the sub-prime mortgage crisis reverberated through the financial sector and became the catalyst for the current global financial crisis.

He told WA Business News that, while the magnitude of the resulting financial market decline was similar, the sharemarket crash of 1987 was bigger in terms of its percentage fall than the sharp downturn last October.

But in 1987, he said, the crash didn't have broader implications for financial firms, unlike the current downturn where a raft of major investment banks crashed.

"The big factor this time around has been the loss of confidence," Mr James said.

"What we can learn from this is that we shouldn't overreact to developments which run outside our own country.

"Unfortunately, what we can't do is legislate changes on human behaviour. There is always going to be fear, there is always going to be greed, and they're two key drivers of financial market behaviour and they have been clearly apparent over the past couple of years.

"Effectively people got too confident and too greedy in the good times, leading investments banks to lend to sub-prime borrowers. What we've seen over the past year or so has been a fear-driven event."

The drop from peak to trough in late 1987 and early 1988 was further and far quicker than the current downturn, Mr James said.

The Australian sharemarket peaked at 2,376.88 points on September 21 1987 and fell 49.2 per cent to its low point of 1,207.51 on February 10 1988, a period of 103 days.

On November 1 2007 the All Ordinaries peaked at 6,853.6 and fell 42.5 per cent to 3,939.5 on October 10 2008, 243 trading days.



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