## FINANCIAL MARKET UPDATE July 2007 ## Source details **Canonical URL:** [FINANCIAL MARKET UPDATE July 2007](https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/fmu/eng/2007/_0707pdf.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/fmu/eng/2007/_0707pdf.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/fmu/eng/2007/_0707pdf.pdf.json) --- ### Executive summary - Financial stability risks have evolved largely as foreseen in the April 2007 Global Financial Stability Report (GFSR). - Clearest area of rising risk: credit—weakening credit discipline has led to rising difficulties in the U.S. subprime market and the leveraged loan market. - Market recognition of credit risk has translated into higher market risk for products based on U.S. subprime mortgages and leveraged loans, with spreads widening and distress at hedge funds exposed to these securities. - Emerging market fundamentals and local capital markets continue to improve, though vulnerabilities persist in some countries due to rapid foreign borrowing and foreign currency exposures. - Assessment: risks have increased and credit markets could remain volatile, but risks are likely to remain largely contained so far; market discrimination by fundamentals is evident and ongoing adjustments should help bolster credit discipline. ### Rising credit risks — U.S. subprime mortgage market - Subprime 60-Day Delinquencies by Mortgage Vintage Year (adjustable rate mortgages, in percent of payments due) show substantial deterioration in more recent vintages, especially 2006. - Weakening of underwriting standards highlighted: increased issuance of interest-only adjustable rate mortgages and mortgages with little documentation. - Underwriting Standards in Subprime Home-Purchase Loans (as presented): - 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 - Metrics shown (column headings implied in source): ARM Share; Interest-Only ARM Share; Low-No-Doc Share; Debt Payments-to-Income Ratio; Average Loan-to-Value Ratio. ### Rising credit risks — corporate and leveraged finance markets - Credit discipline weakened in corporate credit markets: "flexing" of deals in favor of borrowers increased. - Increase in lighter loan covenants: - Volume of ‘Covenant-Lite’ Loans (Jan-Jun, in billions of U.S. dollars) rose sharply (chart displayed in source). - Rising leverage in leveraged buyout (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 (quarterly chart data shown in source). ### Market turbulence and market risk transmission - Market turbulence accelerated when troubles at hedge funds managed by Bear Stearns were revealed on June 15, leading to: - Spread widening on CDOs backed by lower quality mortgage-related collateral; primary market spreads of mezzanine CDO tranches over LIBOR widened across AAA, AA, A, BBB tranches (chart with June 15 marker). - Wider corporate CDS spreads between June 15 and July 9 across US Investment Grade (CDX Main), US Subinvestment Grade (CDX Crossover), Europe Investment Grade (iTraxx Main), Europe Subinvestment Grade (iTraxx Crossover) (chart with June 15 and July 9 comparisons). - Increase in cost of insurance against default by U.S. financial institutions (5-year coverage) for Goldman Sachs, Bear Stearns, Merrill Lynch, Lehman (annual cost for $10 mn face value of senior debt, in thousands). - Concerns intensified after ratings agencies began downgrading subprime mortgage-related securities on July 9. ### Broader markets and volatility - Turbulence was mainly confined to credit markets; flows to emerging market mutual funds saw little impact. - Implied volatility picked up since June but remained below long-term averages (market volatility indices charted; z-score framework described). - Selected asset class returns (May 31 – July 19) showed large negative returns for Subprime Mortgages and Leveraged Loans versus mixed returns across EM Equities, Carry Trades, Gold, Mature Equities, Dollar Index, US/Europe Crossover indices, VIX (chart shown in source). ### Emerging market flows and resilience - Financing flows to emerging markets continued to grow, with a sharp pickup to emerging Europe. - Emerging Markets Total External Financing (1993-Q1 through 2007-Q1) components: Loans, Equities, Bonds (chart shown). - Issuance of International Securities by Region and International Bank Lending by Region show rising flows to Emerging Europe relative to Africa, Latin America, Emerging Asia (charts shown). - Trading volume in emerging debt markets continues to shift toward local market instruments; heavy foreign bank financing correlated with rapid private sector credit growth in some emerging Europe countries (correlation R2 = 0.28, chart shown). - Emerging Market Debt Trading Market Share by Instrument (1997–2005): Local Market Instruments; Sovereign Eurobonds; Corporate Eurobonds; Bradys; Other (chart shown). ### Emerging Market External Financing — reported figures - Gross issuance by asset and region and amortization by asset and region are presented in tabular form for 2001–2007 (quarterly breakdowns and year-to-date totals shown). Example aggregates and net issuance series as printed: - GROSS ISSUANCE BY ASSET: 162.1 135.6 199.8 286.7 410.0 501.7 103.5 126.7 101.9 169.6 133.3 151.0 44.8 53.6 30.2 284.3 - Bonds: 89.0 61.6 99.8 135.1 189.2 182.9 50.4 37.0 34.1 61.5 68.6 72.7 18.8 10.3 10.9 141.3 - Loans (selected series): 61.9 57.6 72.2 106.2 142.5 198.2 30.8 59.5 47.1 60.7 38.6 29.4 12.2 27.1 13.8 68.0 - NET ISSUANCE BY ASSET: 15.2 7.3 80.3 158.6 298.7 396.2 81.4 97.1 73.0 144.6 107.1 120.6 35.3 46.2 17.4 227.7 - NET ISSUANCE BY REGION (selected): Asia 1.5 -1.7 43.3 73.5 112.3 151.2 28.0 36.0 23.3 63.8 27.9 51.8 20.8 18.7 7.7 79.7 - SECONDARY MARKETS (selected series): - EMBI Global (spread in bps): 728 725 403 347 237 171 191 218 208 171 170 181 167 155 181 181 - Merrill Lynch high yield (spread in bps): 795 871 418 310 371 289 313 335 344 289 285 298 274 246 298 298 - US 10 yr. treasury yield (yield in %): 5.05 3.82 4.25 4.22 4.39 4.70 4.85 5.14 4.63 4.70 4.65 5.03 4.62 4.89 5.03 5.03 - Equity indices (select monthly/period changes shown for DOW, NASDAQ, MSCI Emerging Markets index; regional breakdowns for Asia, Latin America, EMEA displayed in series form). ### Policy implications and outlook - The ongoing recognition and repricing of credit risk are concentrating corrections in subprime, leveraged loan, and lower-quality corporate bonds. - Adjustments in structured credit and leveraged finance markets should help restore credit discipline. - Capacity of market participants to discriminate according to underlying fundamentals will be important to keep risks largely contained going forward. *Monetary and Capital Markets Department, Global Markets Monitoring and Analysis Division — Financial Market Update, July 2007* --- _Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/fmu/eng/2007/_0707pdf.pdf_