## Financial Market Update — July 2007 ## Source details **Canonical URL:** [Financial Market Update — July 2007](https://www.imf.org/-/media/files/publications/fmu/0707pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/fmu/0707pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/fmu/0707pdf.pdf.json) --- ### Summary assessment - The IMF’s Monetary and Capital Markets Department assesses that financial stability risks have evolved largely as foreseen in the April 2007 Global Financial Stability Report (GFSR). - Credit and market risks have risen, while continued strong macroeconomic performance and stronger capital bases at systemically-important global financial institutions have underpinned overall financial stability. - The IMF staff’s assessment: “risks have increased and credit markets could remain volatile in the period ahead with a further repricing of some credit products. However, so far, our assessment is that this risk is likely to remain largely contained.” ### Rising credit risks — mortgages and subprime - Subprime mortgage delinquencies have shown substantial deterioration in more recent vintages, especially 2006 (chart: Subprime 60-Day Delinquencies by Mortgage Vintage Year). - Underwriting standards in subprime home-purchase loans (Freddie Mac data): - 2001 73.8% 0.0% 28.5% 39.7 84.04 - 2002 80.0% 2.3% 38.6% 40.1 84.42 - 2003 80.1% 8.6% 42.8% 40.5 86.09 - 2004 89.4% 27.2% 45.2% 41.2 84.86 - 2005 93.3% 37.8% 50.7% 41.8 83.24 - 2006 91.3% 22.8% 50.8% 42.4 83.35 - Causes identified: relaxation of credit standards, increased issuance of interest-only adjustable-rate mortgages, and mortgages with little documentation. ### Corporate credit and leveraged finance - Corporate credit discipline weakened: deals have been “flexed” in favor of borrowers (Standard & Poor’s data show percentage of deals flexed in favor of borrowers rising in recent years). - There has been a sharp increase in the use of “covenant-lite” loans (volume of ‘Covenant-Lite’ Loans in billions of U.S. dollars increased markedly through Jan-Jun 2007). - Rising leverage in LBO deals (Debt Multiples on Private Equity LBO Deals, U.S. deals with EBITDA cashflows > $50 million, show Total Debt/EBITDA and Senior Debt/EBITDA rising into 1Q07–2Q07). ### Market risk and turbulence - Recognition of credit risk in U.S. subprime mortgages translated into market turbulence following troubles at hedge funds managed by Bear Stearns revealed on June 15. - Spreads widened substantially on structured products and lower-quality mortgage-related collateral: - Primary Market Spreads of Mezzanine CDO Tranches over LIBOR (in basis points) show pronounced widening across AAA, AA, A, BBB categories with a notable acceleration around June 15. - Credit default swap spreads on corporate indices rose between June 15 and July 9 (JPMorgan Chase & Co. data show widening across US Investment Grade (CDX Main), Europe Investment Grade (iTraxx Main), US Subinvestment Grade (CDX Crossover), and Europe Subinvestment Grade (iTraxx Crossover)). - Cost of insurance (annual cost of coverage for $10 mn face value of senior debt, in thousands) against default by U.S. financial institutions (Bloomberg L.P.): - Charted names: Goldman Sachs, Bear Stearns, Merrill Lynch, Lehman — spreads widened after June 15 and after ratings downgrades on July 9. - The sizable pipeline of financing for leveraged buyout transactions, coupled with muted investor interest, could pose challenges for banks involved in underwriting and syndication. ### Broader markets and volatility - Turbulence was mainly confined to credit markets; broader markets showed resilience: - Flows into emerging market mutual funds saw little impact (Cumulative Net Flows to Emerging Market Funds, Jan-06 to Jul-07, in billions of U.S. dollars). - Implied volatility picked up since June but remained below long-term averages (Market Volatility Indices, z-score framework). - Selected asset class returns (In Percent, May 31 – July 19) highlighted relative performance and corrections across asset classes including EM Equities, Carry Trades, Gold, Mature Equities, Dollar Index (DXY), US Crossover, Europe Crossover, Leveraged Loans, VIX, Subprime Mortgages. ### Emerging market flows and vulnerabilities - Financing flows to emerging markets continued to grow, with especially sharp increases to emerging Europe: - Emerging Markets Total External Financing (Loans, Equities, Bonds) shows growth from 1993-Q1 through 2007-Q1 (Dealogic). - Issuance of international securities by region (in billions of U.S. dollars) and international bank lending by region show marked growth for Emerging Europe (IMF, International Financial Statistics). - Trading volume in emerging debt markets has shifted toward local market instruments (Emerging Market Debt Trading Market Share by Instrument). - Heavy foreign bank borrowing helped foster rapid private sector credit growth in some emerging Europe countries (Correlation of Credit Growth with Foreign Bank Financing: R2 = 0.28 for 2004–06). ### Emerging market external financing — June data highlights - Gross issuance by asset and region (select aggregated excerpt): - GROSS ISSUANCE BY ASSET 162.1135.6199.8286.7410.0501.7103.5126.7101.9169.6133.3151.044.853.6 30.2284.3 - Bonds 89.061.699.8135.1189.2182.950.437.034.161.568.672.718.810.3 10.9141.3 - Loans 61.957.672.2106.2142.5198.230.859.547.160.738.629.412.227.1 13.868.0 - Net issuance by asset and region (select aggregated excerpt): - NET ISSUANCE BY ASSET 15.27.380.3158.6298.7396.281.497.173.0144.6107.1120.635.346.2 17.4227.7 - NET ISSUANCE BY REGION 15.27.380.3158.6298.7396.281.497.173.0144.6107.1120.635.346.2 17.4227.7 - Secondary markets snapshot (selected lines from June 30, 2006 data): - EMBI Global (spread in bps) 728725403347237171191218208171170181167155181181 - Merrill Lynch high yield (spread in bps) 795871418310371289313335344289285298274246298298 - Merrill Lynch high grade (spread in bps) 1621849383929190979891951009494100100 - US 10 yr. treasury yield (yield in %)5.053.824.254.224.394.704.855.144.634.704.655.034.624.89 5.035.03 - Equity performance (select indices, series shown in table): - DOW -7.1-16.825.03.1-0.616.33.70.44.76.7-0.98.55.74.3-1.67.6 - NASDAQ -21.1-31.550.58.61.49.56.1-7.24.06.90.37.54.33.10.07.8 - MSCI Emerging Markets index -4.9-8.051.222.430.329.211.5-5.14.117.31.814.14.44.64.416.1 ### Policy implications and outlook - The IMF staff notes that the ongoing adjustments in the structured credit and leveraged finance markets should help bolster credit discipline. - The capacity of market participants to discriminate according to fundamentals will be important going forward. - Markets are discriminating on the strength of underlying fundamentals; recent corrections have been concentrated in subprime, leveraged loan, and lower quality corporate bonds. --- _Source: https://www.imf.org/-/media/files/publications/fmu/0707pdf.pdf_