When US economy sneezes …

Asian economies get the chill. The United States of America (US) is still the world’s largest economies. When the Dow Jones Industrial Average (DJIA) closed sharply lower overnight, the Asian stock markets will follow suit when it opened for trading the following morning. (Time difference between US and this part of the world)

This was the case when DJIA dropped more than 400 points on 27 Feb 2007 and then again at more than 200 points on 13 March 2007. The Straits Times Industrial Index (STI) in Singapore suffered in tandem. The Asian stock markets went into the red too.

The latest drop in DJIA (the Dow) 0n 13 March was triggered by the sub-prime US home mortgage wave of defaults. The wave of defaults of “sub-prime” or high risk home mortgages has not only rocked the Dow; it also threatens to ripple through the economy of US. (TIME magazine 26 March 2007 issue)

Why is this so? Time magazine explains.

The sub-prime home mortgage loans are taken by borrowers with poor credit ratings. The mortgage lenders take risk by offering these loans to these homeowners for higher interests.

When the homeowners cannot pay when interest rates rise, they are vulnerable to default and even to foreclosure of their properties.

The sub-prime mortgage lenders get hammered because they have originally resold their high-risk mortgages to investment banks and now they are forced to buy back these bad loans, which hurts their earnings and stock prices.

The investment banks lose businesses because now they cannot repackage these high-risk mortgages and sell them as securities for a profit. As securities get riskier, there are fewer buyers. That means lower profits.

The institutional investors such as banks, hedge funds and mutual funds are exposed to these risky securities (e.g. bonds). As defaults of paying high interest rates on these bonds spread, the promise of interest receipts evaporates.

The end results? The mortgage storm plus slowing consumer spending lead to investors to look for safer bets than stocks. Another fear is when tighter credit further weakens the housing market. (Source: TIME magazine 26 March 2007, page 11)

So the moral of the story, do not ignore the US economy and the Dow’s performance on trading days.

Written on 3/19/2007 9:15 AM

Copyright © 2007, the author known as LKT in Singapore.

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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