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The current crisis seems bottomless. Just days ago, the International Monetary Fund issued their Global Financial Stability Report which increased the estimate of potential losses to $1.4 trillion (Dh5.1 trillion) from last April's estimate of $985 billion.
What exposure a local investor has to these losses depends on what the individual or institution has invested in. The largest category is non-real estate asset-backed securities and collateralised obligations at 38.5 per cent of the total. Real estate is second comprising 29 per cent, with corporate debt at 23 per cent. Commercial real estate and consumer loans trail at 6 per cent and 3 per cent respectively.
These figures include estimated losses on defaults on "real" assets such as loan portfolios and also those from financial aftermarkets. The IMF estimates that $980 billion or 70 per cent of the potential losses will occur in the aftermarkets.
Actual non-performance
In fact, at this point, non-performance of actual US mortgage loans including prime and subprime together accounts for only 12 per cent.
These financial aftermarkets are built on sophisticated financial instruments "derived" from actual assets and are therefore referred to as derivatives. A basic use of derivatives is to dilute the risk that borrowers will default on their obligations.
Since their creation in the 1980s, derivatives have grown to astounding volumes. The IMF report notes that one class alone based on the Libor (London inter-bank offered rate) index is now estimated at $400 trillion. For comparison, the entire economic output of the world last year was $65 trillion, and the total amount of US home loans is $27 trillion.
In other words, derivative instruments which do not represent real assets but are synthetic creations representing commitments to cover losses are more than six times total global output. Maybe more. This is where the greatest risk lies to all investors - local and regional included. This is the eye of the storm in the current crisis.
The IMF believes that it may take four to five years to "de-leverage" these markets. If this can be done without further crisis, then the direct damage to investors is probably reasonably well understood and surprises could be manageable.
But given the staggering magnitude of the derivatives markets - what the IMF calls "dysfunctional securitisations" - all bets are off. This is why we are now observing "a flight to quality", meaning that investors are seeking the safest investments. For now, their concern is not making money, but merely protecting capital.
- Rod Monger is an independent journalist who writes on economic and business issues
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