Investors from the United States to Europe and Asia are facing their first real test of will since the bursting of the internet stock bubble six years ago.
As losses on U.S. subprime mortgage investments have shown up on bank and fund balance sheets around the world in recent weeks, liquidity in global financial markets began to evaporate prompting a corporate credit squeeze that forced central banks to inject more than $300 billion into the financial system.
More than a wake-up call, the subprime mortgage market has suffered a psychological blow whose effects probably will extend well past 2007, Jeffrey Gundlach, chief investment officer at TCW Group in Los Angeles, which manages assets worth $160 billion, said in a letter to clients on Friday.
Stock markets in the U.S. stabilized after losses early Friday, thanks to the biggest cash injection by the U.S. Federal Reserve since the September 11, 2001 attacks.
The Morgan Stanley Capital International All Country World Index, which represents the equity performance of 20-plus countries, including the United States, had seen its market capitalization plunge by $661 billion to $30.9 trillion on Thursday.
But by the end of the week the MSCI world stock index was still down more than 2.0 percent so far for the month, after losing 2.28 percent in July. In emerging markets things are worse, with the MSCI emerging markets index down 6.1 percent so far in August.
DEBT BUBBLE HAS CRACKED
Loose U.S. mortgage lending standards, rising interest rates in 2006, and falling house prices, resulted in increasing numbers of less creditworthy U.S. borrowers defaulting on their so-called subprime home mortgages in 2007.
More than 30 mortgage lenders have gone out of business as a result and Federal Reserve chairman, Ben Bernanke, last month said that about $100 billion or about 10 percent of the more than $1 trillion U.S. subprime mortgage market may be affected.
However, many subprime mortgages are packaged into mortgage backed securities and collateralized debt obligations (CDOs), or bundles of securities with differing yields and credit ratings, which are then sold to hedge funds, banks, and pension funds who want to diversify their risks.
Losses on subprime mortgages have been felt by several hedge funds and banks, including two funds managed by investment bank Bear Stearns, Countrywide Financial Corp, the largest U.S. mortgage lender, and even a German bank, IKB which had to be bailed out by a consortium of state-backed German banks.
In the months ahead, we should expect to see the liquidation of billions more in subprime-related assets by all manner of investors as further waves of downgrades and defaults roll over the market, Gundlach added.
The potential impact of subprime mortgage market losses on banks' balance sheets of banks, and on consumer spending power and U.S. economic growth, has seen concerns about credit risk spread to the corporate bond market as well.
Corporate bond market issuance has fallen during the summer and private equity groups seeking to buy Chrysler LLC, the third largest U.S. automaker, and Alliance Boots, the British pharmacy chain, have struggled to raise the finance for the leveraged buyouts.
On Thursday, France's largest bank, BNP Paribas, stopped withdrawals from three funds invested in securities backed by mortgages, while a crop of hedge funds including two at Goldman Sachs Group revealed this week they have been hit hard by the market's turbulence.
The European Central Bank injected 155.85 billion euros ($214.21 billion) into the banking system in the past two days to assuage investors fears.
Everyone from the ECB to the U.K. to Germany to the president of the United States ... to Canada ... is stepping up to assure us that they're on the case and monitoring markets, said Todd Harrison, founder of Minyanville.
Harrison said central banks have been proactive as opposed to reactive, as major economies have enjoyed economic growth during a period of ultra low interest rates.
My hunch is that they 'get' the globalized finance-based economy's dependence on credit and they're worried that the debt bubble has cracked, Harrison said.
Given our ADD, immediate gratification society, the implications of this latest prick are entirely more profound. And that, I believe, is why the powers that be are wasting no time trying to shore up psychology.
INVESTORS STILL PUT STOCK IN EQUITIES
After enjoying the rally in equities that has seen the Dow Jones Industrial Average hit record highs this year, it appears that a growing number of hedge funds, investment banks and money managers have been blindsided by this month's volatility.
But one group, the small mom-and-pop investor, is still keeping the faith.
TrimTabs estimate that all U.S. equity funds had a healthy $2.6 billion inflow on August 8, while U.S. equity exchange-traded funds had a $2 billion flow and global ETFs got $2.8 billion fresh.
Their participation, however, often signals a short term trading top -- but then again at other times it doesn't, said Charles Biderman, chief executive officer at TrimTabs Investment Research.
Corporate America too has not been shaken by the stock-market decline. At least nine new stock buybacks totaling $1.67 billion were announced on Thursday.
Every day there are many, many new stock buybacks being announced and a source at a major trading desk says that actual buybacks are continuing at a fast and furious pace, said Biderman.
All told, one market maven isn't calling for the end of the bull market.
Abby Joseph Cohen, chief investment strategist at Goldman Sachs, said on Friday that U.S. stocks are underpriced by about 10 percent.
That level of discount in the markets provides usually a good entry point, she said.
Cohen, speaking on the television channel CNBC, said that the benchmark Standard & Poor's 500 Index is trading about 10 percent off its fair value, which she put at about 1,600.
The S&P 500 was up 0.55 of a point, or 0.04 percent, to finish at 1,453.64, off a session low at 1,429.74 earlier on Friday.