Jeremy Warner's Outlook: Stock market correction heads for crash

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The Independent Online

All the old stock market clichés are wheeled out at times like these. One of the most apposite is "never attempt to catch a falling knife". As turbulence in stock markets descends into a fully-blown rout, those with cash to invest have chosen to stay on the sidelines, even though many stocks have now quite plainly become a screaming buy. Nobody is going to risk a penny while the present state of uncertainty as to mortgage-backed security losses and the effect of the present credit squeeze on the real economy persists. It may be some months before we get a clear picture of the damage.

With the FTSE 100 down around 12.5 per cent since its June peak, we are now some distance beyond what by stock market convention qualifies as an official "correction". The more alarmist term "crash" is allowed once stocks fall more than 20 per cent. As can be seen, the market is well on the way.

I have to admit that I failed to anticipate the scale of the present blow-off in share prices. The over-leveraged state of the financial sector was certainly indicative of over-exuberance in markets, but the underlying economy seemed sound and stock market valuations were undemanding. It therefore seemed reasonable to assume that any correction would be shallow and short-lived.

The sell-off of the past few weeks can no longer be characterised as shallow, yet I'm inclined to hold firm to the view that it is likely to prove temporary. Bear markets are generally sparked by a decisive trigger, and it can certainly be argued that we have had that in the freezing up of credit markets of the past fortnight.

Yet they also need to be fed and nurtured by the likelihood of recession. This is as yet a key missing ingredient in the current turmoil. The world economy is strong with no obvious reason to expect a sharp downturn other than the wholly unscientific argument that all booms must eventually wither and die.

In fact, booms very rarely die of old age as such. Instead, they tend to get murdered by the anti-inflationary actions of central banks. Quite so, argue the bears. Over the past couple of years, the US Federal Reserve has been progressively removing the punch bowl with a monetary tightening which has taken the US bank rate from just 1 per cent little more than two years ago to 5.25 per cent today. This has caused all manner of problems with indebted Americans, prompting certain areas of the economy to slump.

It is perfectly possible that these negatives will in time push the whole economy into recession. The odds on such an outcome have certainly shortened markedly in recent weeks. Yet such an outcome would also be quite out of kilter with the forecasts of most mainstream economists, central bankers and Western governments. Only the perma-bears would have seen it coming.

Yet this would not always have been the case. Once upon a time, the bear argument would have been almost universally shared. What has changed since is the rise of China and other emerging market economies. In a circular entitled "Thank God for China", Jim O'Neill, global head of economics at Goldman Sachs, points out that Chinese consumption is already not that far off contributing as much to the world economy as the US consumer. Chinese growth powers on, providing a crucial counterweight to events in the US.

It is when China falters that the real cause for concern arises.

Rating agencies under the spotlight

Whenever there is a financial crisis, the rating agencies get it in the neck for failing to predict what with the benefit of hindsight always looks like the blindingly obvious. It happened with the Asian crisis in the late 1990s, with the corporate crisis of 2000-2003 and it is happening again with today's mortgage-backed securities crisis.

On all occasions, the agencies were slow to downgrade the debt instruments involved. What's more, the benign ratings initially assigned to these securities may have encouraged their wider take-up, thus helping to create the mispricing problem. As in previous crises, the rating agencies find themselves in the firing line.

Both in Europe and the US, they are the butt of criticism from regulators and politicians alike. Charlie McCreevy, the EU internal market commissioner, has already summoned in senior executives of Standard & Poors for a dressing down. Their role has also been questioned in the US by Barney Frank, chairman of the House financial services committee. Rating agencies make convenient scapegoats, but are the criticisms justified?

Only in part. In fact, all three of the main agencies have been expressing varying degrees of concern about the build-up of credit risk for some time now. They'd have to have been on a different planet not to have noticed it, and, for all their faults, they are not that blind. Their warnings have nonetheless fallen on deaf ears in over-exuberant capital markets.

Nor can the agencies reasonably be blamed for the way in which a comparatively minor problem in the sub-prime sector of the US mortgage market has mushroomed into an all-embracing credit squeeze and flight from risk. This is a sentiment-driven phenomenon for which the rating agencies are not responsible.

Nonetheless, they have plainly played their part. The present crisis finds its roots in the way debt has progressively been taken away from banks over the past 20 years and securitised in the capital markets. This has been in many respects a healthy development which has helped to spread credit risk and thereby take away the rougher edges of the old banking cycle. Yet it has also transferred the role of credit assessment from its traditional home among bankers to the teenage scribblers of the credit-rating agencies.

The securitisation of credit has also made it less easy for regulators and central bankers to monitor credit risk, establish where it might lie, or to rein it. It is this state of unknowing which lies at the heart of the current debate over whether credit derivatives have made the financial markets a safer or more dangerous place. Sentiment at the moment leans very much to the latter point of view.

To the extent that there are yardsticks of credit risk in today's supercharged global capital markets, they are provided by the credit-rating agencies. The ratings they assign are not intended to predict which instruments might default as such, but, based on experience, to provide a probability of the risk of default.

On this score, the record is actually not that bad. Whenever there is a default on investment-grade paper, the agencies get blamed for not having spotted it, yet no system can provide a 100 per cent guarantee of solvency.

Where the rating agencies are open to criticism is that they tend to be quite bad at responding to financial innovation, if for no other reason than they have no experience of these newer forms of debt and are therefore unable to apply reliable default probability criteria to them. Unfortunately for the agencies, there are few places quite as innovative as Wall Street and the City, so they are constantly assailed by ever more exotic products. Many of these products have not been properly understood and have therefore been mispriced.

Yet it has always seemed to me the main problem with the credit-rating agencies is that there are too few of them. In the big league, there are only two, Standard & Poor's and Moody's, plus an also-ran, Fitch. After that, the industry becomes highly fragmented and niche. This cannot be healthy, for it is bound to discourage alternative thinking and analysis. Nor does a system that allows the agencies to take a fee out of the borrower as well as the lender seem at all desirable. The potential for conflict of interest is all too obvious. Quite a lot of corrective good is likely to come out of the present panic. Reform of the credit rating system may be part of it. Let the debate begin.

j.warner@independent.co.uk

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