When America sneezes the rest of the world catches a cold. And what is true of the US economy is no less true of its financial markets. Credit worries on Wall Street are rapidly transmitted to global stock markets, as volatile trading in international equity markets over recent weeks illustrated. Sharp fluctuations and falls in share prices in New York have been replicated on European and Asian exchanges, with Dublin among the hardest hit. In July, the value of Irish shares fell by some 8 per cent, a steeper decline than in most other equity markets.
This latest bout of global financial turbulence stems from difficulties in America's subprime mortgage market, which lends to borrowers with poor credit records. Rising interest rates and falling property prices in the US, when allied to reckless borrowing and imprudent lending practices there, have produced a very dangerous mix. For some US banks lent borrowers too much money, too easily, for house purchases, without adequate scrutiny either of the income or assets of the borrower, or the homebuyer's ability to service these loans. Later, as interest rates rose and property prices fell, many subprime borrowers experienced negative equity, where the value of their loan exceeded the value of their home. And as they were no longer able to meet higher mortgage repayments, they defaulted on their debt.
The banks, however, had protected themselves against default, by repackaging and reselling these loans to other financial institutions, as securities backed by subprime mortgages. So they diversified their credit risk, by transferring that risk to the buyers of those securities, both in the US, and beyond. At issue now is the location and extent of that credit risk, something that is proving very difficult to establish. The resulting uncertainty helps both to account for investor nervousness and to explain recent market instability, where bank stocks in particular have come under some selling pressure.
In reality, however, the difficulties in the US subprime credit markets are really a symptom of a larger global problem, a liquidity bubble. This financial bubble, which is the by-product of years of record low interest rates, has helped to fuel asset prices, most notably property, to highly inflated levels. But the crisis in the subprime mortgage market has now precipitated a major world-wide reassessment and re-pricing of financial risk. As lenders become more risk averse, tighter credit conditions are being attached to new loans, thereby making some private equity deals harder to finance.
Ireland, as part of a globalised world, is not immune from the financial fallout from these events. And as the shares of financial and construction companies account for some two thirds of the market value of those listed on the Irish Stock Exchange, the 8 per cent fall in the value of Irish shares last month, while unwelcome, was hardly too surprising in the circumstances. Nevertheless, this modest market correction should not, as yet, give too much cause for investor concern.