IMF Survey: Financial Conditions Strong but Risks Rising
IMF News, April 12, 2007
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- Authors: Ina Kota IMF Survey
- Published: April 12, 2007
Global financial environment — overview
- Global economic conditions are underpinning a positive financial environment.
- Financial market volatility across a broad range of assets "remains at remarkably low levels" and risk spreads "remain tight," according to the IMF's April 10 report.
- The IMF raised its assessment of market risks because "a market correction, potentially triggered by a `volatility shock,' could be amplified by leveraged positions and uncertainties about concentrations of risk exposures."
- Report date and publication context:
- IMF Survey online, April 12, 2007.
- Assessment compares conditions to the September 2006 Global Financial Stability Report (GFSR).
Key short-term market risks (identified in the report)
- The report identified four key areas of heightened short-term risk:
- The U.S. subprime mortgage market.
- Leveraged buyouts (LBOs).
- Capital flows to emerging markets.
- Global imbalances.
- Additional market-wide concerns:
- Growth of carry trades as evidence that market participants do not view current low-volatility, high-liquidity conditions as likely to reverse soon.
- Competitive pressures and risk models may perpetuate risk taking, potentially causing a collective buildup of investment positions that could lead to a disorderly correction.
U.S. subprime mortgage market — findings and exposures
- The subprime segment of the U.S. housing market is showing "signs of credit quality deterioration."
- The fallout to date has been "limited and diffused" but could deepen and spread to other markets, possibly to structured mortgage credit products held globally.
- Size and foreign holdings of U.S. residential mortgage-related securities:
- Totaling about $5.8 trillion as of January 2007.
- Non-U.S. holdings estimated at $850 billion as of mid-2006.
- Concentration and contagion risks:
- Credit risk concentrated among subprime borrowers, but underwriting weaknesses could extend to higher-quality mortgage collateral.
- Anecdotal evidence suggests overseas investors and hedge funds have significant exposure to riskier portions of the collateralized debt obligation market exposed to subprime risks.
Leveraged buyouts and corporate credit risks
- Low interest rates and healthy corporate balance sheets have spurred an increase in private equity buyouts, raising leverage for bought-out firms.
- Characteristics of the current LBO wave:
- Target companies are "much larger" than in the 1980s and late 1990s.
- Use of loans is expanding more than that of high-yield bonds.
- So far, target firms are mostly those with strong cash flows and low debt, but some acquired firms have become heavily indebted.
- There appears to be less due diligence and a general weakening of loan covenants in recent deals.
- Overall IMF assessment: credit risks have increased since last September, although from a low level.
Emerging markets, capital flows, and global imbalances
- Capital inflows to some emerging markets have risen rapidly, reflecting improved fundamentals and the search for yield due to low real interest rates in most mature markets.
- Shift in flow composition:
- Movement toward private sector debt flows, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa.
- Risks and vulnerabilities:
- Rapid inflows pose challenges for authorities and could threaten financial and economic stability if flows reverse.
- In some countries, strong sovereign external positions may mask vulnerabilities among corporations and banks.
- Global imbalances:
- Downside risk from a possible disorderly unwinding of global payments imbalances "has receded" but remains a concern.
- Larger role of fixed-income inflows in financing the U.S. current account deficit suggests inflows may be more sensitive to changes in world interest rate differentials.
Rising credit risks and market behavior
- Corporate profits appear robust, balance sheets are strong, credit spreads have declined further, and default rates remain low.
- However, corporate debt in private markets is rising from low levels due to the boom in leveraged buyout activity.
- Market participants may be giving insufficient weight to downside risks, assuming low risk premiums are semipermanent.
- Collective rational risk taking by institutions could raise systemic risks through concentration and leverage.
Policy recommendations and implications for authorities
- The report urges policymakers to manage stability risks by:
- Ensuring investors adequately understand and appreciate the risks they are taking.
- Paying careful attention to LBO activity, especially large high-profile deals that could trigger wider reassessments of risk.
- Monitoring rapid capital inflows to emerging markets and associated private-sector vulnerabilities.
- Authorities should be alert to amplified effects of a volatility shock given increased linkages across products and markets.
Source: IMF Survey: Financial Conditions Strong but Risks Rising (IMF Survey online, April 12, 2007; Global Financial Stability Report referenced April 10).