February 1, 2009

Financial Contagion in Credit Markets

Thursday, September 06, 2007
by Chris Buzzard

The ongoing U.S. subprime credit crisis has received significant attention from the domestic media and even here on the Aplia Econ Blog. However, recent developments suggest that this credit crisis might be spreading to the rest of the world. Around the globe, a credit crunch is being felt in subprime markets, as well as in safer prime mortgages and leveraged lending. The World Bank defines financial contagion as “the cross-country transmission of shocks or… general cross-country spillover effects,” but notes that the term is generally used to describe the spread of financial crises. Distress in one country’s financial system can be “contagious” and spread to other countries whose interests are tied to the “sick” country.

When a financial crisis begins to take hold, the old saying goes that “cash is king,” leading investors to sell off securities and flock from risky positions. The result is depressed stock prices, lower Treasury yields, and higher default spreads. Default, or credit, spreads are the additional premium investors require to hold a security based upon its default risk. According to the article, many carriers of the crisis “bug” are credit hedge funds that face rising leverage due to falling collateral values, illiquid markets, and tighter lending policies from brokers. Leverage exists when investors finance their investments with borrowed funds (debt).

The effect of financial contagion is stronger the more institutions and investors in different countries have vested interests in each other’s financial markets. These interests may be direct equity or fixed-income investments, or they may be complex financial arrangements (which may or may not be collateralized), such as interest or exchange-rate swaps, or arbitrage portfolios designed to profit from market imprecision.

A famous illustration of the effects of financial contagion is the case of Long-Term Capital Management (LTCM), a hedge fund founded by bond guru John Meriwether whose board of directors included Nobel laureates Myron Scholes and Robert Merton. LTCM’s fixed-income arbitrage strategies provided investors with astonishing returns over its first few years, until a series of unfortunate events in 1997 and 1998 crippled the fund. The collapse of the Thailand property market spread throughout east Asia, causing panic and massive selling as market volatility soared to record heights. LTCM believed it was properly hedged to weather the storm—as long as the Asian crisis was an isolated event. Unfortunately, it wasn’t: in August 1998, Russia unexpectedly refused to honor its international debt, causing investors to flock toward liquidity in the U.S. Treasury market. The real effect of these crises was to cause investors to take cover from losses and to cause markets to behave in unprecedented ways.

Discussion Questions

1. Interest rates are supposed to reflect an investment’s risk. Why is it, then, that in a financial crisis (like the current subprime fiasco), Treasury yields actually go down?

2. What might be a larger concern regarding contagion if it extends beyond financial markets?

3. Why does a financial crisis that causes depressed stock prices and asset values also cause investors’ and institutions’ leverage to increase?

4. The effect of leverage can be quite staggering, as seen in the case of LTCM, whose ratio of assets to liquid capital reached 30 to 1 in the middle of its meltdown. Suppose you run a hedge fund that leverages a $20 million equity investment into $100 million of managed assets. If poor market conditions cause your fund’s managed assets to decline in value by 5%, the new value of managed assets becomes $95 million. But what is the percentage decline in value of your fund’s equity position?

5. Drawing from the previous example, imagine now that your fund is even more leveraged, and the $100 million in assets is supported by only a $10 million equity position. Now what is the percentage decline in your fund’s equity position due to a 5% decline in the fund’s managed assets?

Credit Default Swaps

Leverage and Deleverage

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