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The US economic downturn is already taking its toll on global markets. In this issue of The Middle East three specialist commentators give their opinions on where the crisis in America will leave the oil-producing Gulf states. Skilled economic analyst, Moin Siddiqi,

looks at the run-up to the crisis which has resulted in a scale of credit losses unparalleled in modern banking history. Jeff Black examines the Gulf's exposure to a US downturn; while international financial expert analyst, Pamela Ann Smith, presents the case for why the oil-producing GCC states, while not immune, will be protected from the worst effects of the downturn.

THE US SUBPRIME meltdown and ensuing wider credit squeeze (i.e. the amount of money circulating in the banking system) has hit the balance-sheets of banks worldwide, thereby hurting companies and consumers alike. "Financial market strains originating in the US subprime sector--and associated losses on bank balance sheets--have intensified, while the recent steep sell-off in global equity markets was symptomatic of rising uncertainty," the International Monetary Fund (IMF) stated. In all likelihood, 2008 will prove a less benign year for financial institutions amid broader growth slowdown (especially in the advanced OECD economies), which is now underway. Where do Arab banks stand in the market turmoil that first erupted last summer, only to become worse as western banking giants disclosed tens of billions of dollar losses?

Stock markets are unstable at the best of times, though the present volatility is unprecedented. It's puzzling how subprime mortgages to those with impaired or limited credit histories or so-called 'Ninja' loans to families lacking real collateral could have such a 'catastrophic' impact on the global financial machine. At the end of 2006, subprime loans represented 15% ($1.5 trillion) of outstanding US mortgages, but soaring interest rates (rising from 1% in 2003 to 5.25% by mid-2007) triggered a wave of defaults across America. The US Federal Reserve initially estimated subprime losses at a mere $50bn--which proved grossly inaccurate. It shows even the world's No.1 central bank with sophisticated macroeconomic models was unable to foresee the near-term market conditions.

A wider crisis quickly emerged as many of these risky mortgages were bundled (i.e., repackaged) into complex chain of debt securities and sold on to investors including banks, insurance companies and hedge funds as 'triple-A' investment grade paper--with the full blessings of major credit-ratings agencies namely Standard & Poor's (S&P), Moody's Investors Service and Fitch Ratings. Most hefty losses have centred on the so-called instruments--Collateralised Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs)--that proved like any other sub-investment grade 'junk' securities.

CDOs are derivatives supported by pools of less risky assets such as residential mortgage backed securities (RMBSs) or mortgages on commercial properties (CMBSs) with differing repayment/interest earnings streams, plus different probabilities of default. In the event of default, the higher-risk 'equity' tranche absorbs the first loss from anywhere in the portfolio, up to a limit. Hereafter, the next least-secured tranche absorbs the additional principal loss and so on. The [paper] value of the global CDO market is estimated at $2 trillion, of which a quarter, or $500bn is probably worthless because of defaulting securities.

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SIVs are off-balance sheet vehicles that invest in diverse longer-term assets including mortgages and bonds--funded from short-term debt. The SIV structure was designed to turn fractional differences between the cost of short-term funding and the yield of long-term, mostly very safe investments into big profits. Assets under SIV business totalled $395bn in mid-2007, according to Moody's. The credit crunch has effectively ended SIV funding as the London Interbank Offered Rate (LIBOR) rose steeply in the second half of 2007, thus eroding long-term returns.

In a nutshell, structured credit products were highly contagious with hidden risks, but financiers viewed them as lucrative assets for earning easy profits.

The Financial Stability Forum, a committee of international supervisors and central bankers, spotted failures at all levels of the system that undermined market confidence--from "fraudulent practices" by some US mortgage lenders, poor due diligence by investors and underwriters and mistakes or pure incompetence of ratings agencies to identify the level of risk associated with asset-backed securities. This undermines investors' faith in S&P and Moody's.

The Group of Seven (G7) finance ministers estimated the potential size of subprime-related losses at $400bn--sharply steeper than the $100bn-$150bn calculated last autumn by the Federal Reserve. About half of the G7 figure lies within US shores with the rest spread across Britain, France, Germany, Switzerland, Japan, Korea and Taiwan, where financiers became creative at repackaging these secondhand loans. To date, major US and European banks have revealed about $84bn and $40bn, respectively, of 'bad debt' exposures. While Japan's financial watchdog disclosed Japanese banks suffered losses of $5.6bn at end-2007 on CDOs, which appears, however, a conservative figure.

The scale of credit losses is unparalleled in modern banking history. The IMF warned that harsh economic conditions could "exacerbate pressures on major financial institutions", which have already revealed staggering credit losses from subprime mortgage woes on their books. The biggest banking write-downs (reduction in the value of an asset) were reported by Merrill Lynch ($24.5bn) followed by Citigroup ($22.1bn), UBS ($18.4bn), HSBC ($10.7bn), Morgan Stanley ($9.4bn) and Bank of America ($7.9bn). On the medium-to-smaller scale losses were Credit Suisse ($Sbn), Deutsche Bank ($3.2bn), Barclays ($3.1bn) and Fortis Bank ($1.4bn).

There is now a question mark over capitalisation of some western banks after huge write-offs. According to Barclays Capital report, the OECD-based banks may need capital injections of as much as $143bn to absorb write-downs on distressed debt securities in recent months. The British investment bank notes: "Unfortunately the write-downs and losses to date by no means represent the end of the story. That said the dimensions of the likely losses are large enough for there to be a clear need for considerable infusions of fresh capital."

Regrettably credit problems are slowly affecting the broader economy. This, in turn, will impact consumer and commercial property lending businesses. More worrying, delinquencies (i.e., default rates) on US 'prime' mortgages (given to the most creditworthy borrowers) and other forms of consumer debt--including credit cards and auto loans--rose during 2007, albeit from low levels. Analysts reckon that losses on unsecured private loans and the real estate market could eventually total between $100bn and $200bn, assuming consumer spending (which comprises two-thirds of the US's GDP) falters this year. "A possibly deeper economic downturn in the US or elsewhere could also serve to widen the crisis beyond the subprime sector, as credit deteriorates more broadly," the IMF notes in its January 2008 Global Financial Stability Report.

Besides mortgage assets, many western banks are expected to make heavy provisions on corporate leveraged loans that are now trading on the secondary markets at less than 90% of their original face value. These loans are rated below investment grade (BB+ and lower by S&P or Fitch and Baal and lower by Moody's) to firms with a higher debt-to-earnings ratio or trade at wide spreads over LIBOR (i.e. exceeding 150 basis points). The US banks are under pressure from regulators to write-off the value of their [unsold] leveraged loans.

Turning our focus on the Middle East where banks were also tempted to buy high-yielding securities, though their subprime exposure remains low (related to total assets) compared with other regions. So far, Gulf International Bank, Arab Banking Corp, Abu Dhabi Commercial Bank, Bank of Bahrain & Kuwait and Saudi Investment Bank have reported write-downs of $1,000m, $230m, $152m, $62m and $14m, respectively, on their 2007 accounts. Others vulnerable to credit losses include National Commercial Bank and Gulf Investment Corporation.

Analysts estimate structured finance write-downs could reach $2bn during 2008. But even a bad debt of $3bn-plus is a drop in the ocean compared to the 'colossal' losses reported by western-banking giants (notably UBS and Citigroup). Moody's comments: "Fortunately we do not expect to see much spill-over into other asset classes and very few banks in the region are exposed." S&P agrees: "Exposure is limited with a few exceptions, with the higher provisioning expected mainly in Bahrain but also some in the UAE and Saudi Arabia."

This aside, buoyant economic activity underpinned by a tenfold hike in oil prices in the past decade has generated vigorous domestic demand, fuelling strong credit growth and helping to improve asset quality. Therefore, sound fundamentals and favourable demographic dynamics point to sustainable loan growth in future years. Randal Goldsmith of S&P Fund Services, said: "There is some sustainability built into growth. A lot of the money [oil windfalls] is being ploughed back into infrastructure and developing infrastructure can take years." HSBC expects $150bn worth of real estate projects to enter the market [in the UAE alone] over the medium-term. Higher capital spending has positive 'multiplier effects' upon the industrial and services sectors.

Banks' heavy exposure to the construction industry remains a worry in some Gulf countries (notably the UAE). However, impairment charges and other credit provisions on the regional housing market remain 'negligible', with paltry levels of defaults thanks to prudent lending policies based on borrowers' credit scores, debt service-to-income and mortgage loan-to-value ratios.

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The Institute of International Finance (IIF), a Washington-based association of private banks, said with the improvements in provisioning and risk management systems, even a sharp downturn in the region's property sector "would not provoke a systemic crisis" in any Gulf Cooperation Council (GCC) country.

The majority of Arab banks don't need to replenish their capital base like some US and European groups, via emergency rights issues or convertible bonds (e.g. Citigroup). The average capital ratios of regional banks comfortably exceed the 8% minimum benchmark set out in the 'Basel 1' Accord (the GCC central banks impose a higher capitalisation requirement). By contrast, Mervyn King, the governor of the Bank of England, advised the UK's largest banks to rebuild their depleted capital reserves. For instance, tier-one capital (i.e. shareholders' funds) of the Royal Bank of Scotland (RBS) as a proportion of risk-weighted assets fell to only 4%, the lowest in Europe. Not surprisingly, RBS's share price has plummeted by 40-45% since end-June 2007.

Moreover, GCC-based banks are more proactive in writing-off their legacy of non performing loans (NPLs), and hence, the average ratio of NPLs to gross loans has declined to under 5% in most GCC countries, on IIF figures. The 2006 nosedive of regional stock markets (led by Saudi Arabia TASI) prompted many banks to improve their risk management systems, whilst boosting their tier-one capital and provisioning levels. The balance sheets are not over-geared--concurrently loans and advances fall well below the level of deposits and more importantly, Arab banks are generally not involved deeply in the 'poisonous' businesses of structured debt securities. And, as a sign of stable funding, local banks benefit from a stronger retail and government deposit base.

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Despite gloom at the health of Wall Street banks, the world economy is in reasonable shape, in contrast with the 'stagflation' problems of the early 1990s--with falling output and rising inflation. The US accounts for 20% of the world's gross domestic product (GDP), thus if key emerging markets Brazil, Russia, India and China (BRICs) as well as Arab oil-exporters, achieve healthy growth (highly likely), we should avert a worst-case scenario of a global recession crippling manufacturing, retailing, and house building sectors, through to commodity markets--and therefore faltering demand for crude oil, the most-traded commodity.

The IMF has lowered its 2008 world growth projection from 4.4% to 4.1%. A combination of large interest rate cuts from the Federal Reserves (Fed) and a fiscal stimulus package from Congress reduce the risk of a severe downturn in 2008/09. The Fed sees the US economy growing at about 1.3-2% this year, down from the previous forecast of 1.8 to 2.5%. Bob Diamond, president of Barclays Bank, thinks an American downturn would be "shorter and shallower" than bearish forecasts suggest. The good health of the US--the world's No.1 energy consuming market--is critical to the Middle Eastern oil-exporters. Crude demand and prices could weaken substantially if US fuel consumption starts falling.

Major financial groups are likely to face tougher market conditions in the first-half with more reporting of credit losses on asset-backed securities. Regional Arab banks are not totally immune to mayhem in the American housing market. On the corporate side, the global credit crunch may enable local players to participate in syndicated mega-project finance deals as western banks cut credit lines to emerging markets. Over the years, however, Arab banks' share of deals and margins has been squeezed by competition from multinational banks, which have provided cheaper longer-term funds for infrastructure projects.

Some local banks have tapped external funding to support their long-term lending (through project finance and mortgages). But the IIF warns it's generally a more expensive option than customer deposits and exposes banks to volatility in the global capital markets. Foreign borrowing is now very costly, particularly for small and medium-sized institutions, reflected in higher LIBOR.

Ironically, financial turbulence in the past half-a-decade--thus affecting global expansion--has mainly emanated from America when we consider the impact of the dot.com bust, series of corporate scandals (notably WorldCom and Enron, once the US's seventh-largest energy firm), Iraq's catastrophic 2003 invasion and now anxieties over the US economy sliding into a 1990s Japan-style depression thanks to spill offs from the subprime housing fiasco.

In the final analysis, the credit crisis should not have knock-on effects on consumer and corporate sectors in the Gulf, thus reflecting low external borrowing and massive oil-fuelled liquidity. The McKinsey Global Institute estimates that GCC countries alone will net extra revenues of $3.8 trillion if oil prices remain strong over the long-term.