Wednesday, October 03, 2007

Subprime and the Rocking Markets

Nothing can beat this. No one can afford to ignore this. This certainly is the biggest news this week. Another punch from the Markets after the 15000 mark. Sensex crosses 16000. Wowwwwwwww. A month back we were seeing the downturn and we are all back as a phoenix which will rise from ashes. Let’s go back a little bit to analyze as to what happened.

Subprime shockwave, Fed Funds Rate, Discount Rate, Ben Bernanke, Northern Rock, Countrywide Financial, Emerging Markets decoupling, These are the some of the key words which we have heard over a period of last two months day after day. The list is just endless and goes on and on. All the business news channels and the financial news paper kept on talking about the Subprime phenomena and US entering into a recession. It was also said that very soon India could also see the impact of subprime shockwave, which will hit the equity markets badly and will end the emerging markets story in one shot. But as of today 23rd September, we stand tall and straight and absolutely fine at a cool 16564 mark. Yes the benchmark index for the country SENSEX has kissed 16000 with the NIFTY cruising to 4800 mark after the Fed announced the rate cut in the Fed Funds rate by about 50 bps and the discount rate by 50 bps.

Going back to the month of July when I was working with one of our client’s and I heard the term called as Subprime and how it can hit the markets hard. I was just waiting to understand the complete picture but before that the Dow and NASDAQ reacted and on August 2 we saw the first collapse in Dow and NASDAQ. A fall of about 3-4 % leading to a worldwide belief that the bull run of the equity markets has come to an end. Asian markets fell by a good 3 % that day with Indian markets tumbling down by over 4 % lead by Reliance and Infrastructure stocks.

Lets understand the phenomena of Subprime and how does it affects the equity markets globally or on a larger basis US Market. Subprime is a term which is coined for borrowers who do not belong to the prime category of borrowers. This happens because of the fact that these borrowers have a bad credit history, have defaulted on previous loans and credit card payments or have no sufficient collateral to back up their loans. The best way to describe them is the word NINJA. NINJA stands for No Income No Jobs and Assets. We know from finance that lower is the credit rating of the borrower higher is the interest rate charges. So for the subprime borrowers the interest is charged at a higher rate when compared to prime borrowers. The term subprime actually refers to the borrower’s quality unlike the interest rate in India.

In the last 5 years Fed has cut the rates for the first time on last Tuesday. This means that rates have been northward from the last five years primarily on the inflation concerns since Alan Greenspan who was the Fed Chairman before Ben Bernanke, felt that rate has to be under a strong control to contain the inflation. Due to this, the sub prime borrowers now had to continuously pay higher rates on their existing home loans. Only way to counter this increase in the home loan rate was to refinance the loan. Refinancing the loan involves again a cost, which may not be able to match up with the lower interest rate. In late 2006, the first signs of Subprime came into picture when a few of the home loan borrowers started defaulting. But then the news died since the stakes involved were not very high.

The first shock of Subprime hit a large scale US Investment Bank, Bear Stearns. Bear Stearns announced that it has made a huge loss of $ 2 billion in one of the hedge funds it runs. Now to understand the connection between subprime and hedge funds lets go back to the concept of securitization. Securitization is a concept of repackaging illiquid assets and selling them as high yield securities. This happens normally in case of home loans, credit card receivables and a lot of illiquid homogeneous assets. Now a lot of financial lenders like Countrywide Financial actually sold their subprime loans to prominent investment banks globally which in turn created hedge funds out of them and sold the securities in the fund to investors. Why should investors buy the securities? Simple in return for the risk they take they get a high yield probably much higher than what they can get on a treasury bond.

As the subprime borrowers started defaulting more often, the value of the hedge fund started falling. This went on to such a extent that Bear Stearns declared that one of its hedge fund will not be in a position to allow any further redemption because the value of fund has fallen considerably. When the investment banks realized that the Hedge funds based on subprime loans are not sustainable, they decided not to buy any more home loans from financial institutions like Countrywide which in turn hit the latter badly since it started accumulating bad loans on its balance sheet. This soon became worldwide phenomena with prominent investment banks like Lehmann Brothers, Goldman Sachs etc closing their mortgage services and cutting jobs extensively. BNP Paribas in France stopped redemption of one of its fund. In the Far East, Macquarie Bank in Australia closed one of its hedge fund which had exposure to US subprime market. Due to higher home loan rates, the housing market hit a record 20 year low in US which actually forced Countrywide to close some parts of its business and cut jobs rapidly. This also led to collapse in the equity markets and Dow saw its worst time since 2001 falling by more than 400 points in a single day triggering the world wide collapse of the equity markets. So this is in brief about Subprime problem.

Subprime issue had spread to such an extent that now it was felt that if Fed does not jump in and take some action, US may enter into a recession. Soon Fed showed its colors and cut the discount rate by 25 bps. Discount window of Fed allows the banks to borrow emergency funds from Fed which are repayable in a month’s time. This actually gave a relief to the markets and globally all the indices went up marginally over this news. Then came the news that Countrywide is about to get busted when it went to 12 different banks in US for a $ 12 billion credit line. The markets reacted again and fell by more than 4 %. Nifty went below 4000 mark and Sensex went until 13787 levels. The punters said that the bull market run had ended for the emerging economies.

Slowly and steadily the news about Subprime losses stopped coming. It was felt that Indian markets are not prone to such markets and hence a decoupling theory was suggested for the same. Decoupling from the US markets, which actually helped the Indian markets considerably. Indian markets started recovering quite well but the recovery was seen only in quality stocks or stocks which are fundamentally good like Reliance, L&T, BHEL and couple of others. While Index was rising slowly and trying to reach the previous highs the rising dollar hit the IT companies badly. In the past few months the IT stocks have fallen to an extent of more than 5-10 % with some stocks hitting 52 week low also.

On September 18, Fed made its announcement about rate cut. Markets were expecting a rate cut of about 25 bps in Fed funds rate. But to everyone’s surprise the Fed fund’s rate was cut by 50 bps and the discount rate was cut by another 50 bps. This was an enough trigger for the markets and Dow and Nasdaq went up in the last hours of the trading session by almost 3- 4%. Next morning we had a huge rally in the Asian markets with the Hangseng and Nikkei 225 moving by more than 4 % in a single trading session. Indian markets were not far behind with Nifty crossing 4700 mark and Sensex crossing the 16000 barrier. Most of the stocks touched their 52 week high.

The rate cut by Fed is a sign of two things. One is to ease the liquidity in the markets to ensure that US keeps growing at about 2 % every year. Second is that the subprime problem is big enough to entangle the entire US into it. This can affect the US housing market which has seen the biggest slump in last 9 years.

As I complete this article, which has now taken close to a week, Market globally; have risen to lifetime highs in each and every sector. Whether it is mid cap, large cap or small cap everything has risen astronomically and some stocks are daily making new Highs. Reliance pack especially has risen like anything with some stocks getting completely out of their fundamentals. RNRL moved by close to 30 % in a single day followed by JP Hydro which moved by 28 % in a single day together with RPL which moved by 16 % in a single day. It has been a maniacal rally for the markets and more is yet to come that’s what analysts say across the world. As I write this article we are looking at breaching the 18000 mark on SENSEX and 5500 on NIFTY very soon.

2 comments:

Anonymous said...

excellent write up on subprime lending
I am aditya an mba student from FMS delhi
thank u fr this article
want more such simplified ones


adita modi
FMS delhi
adityam.fms@gmail.com

Rachana's blog said...

Hey Yash, After a long time I am reading your blog and I was not dissappointed, I learnt a few things.

I would like to add a few thing to the article. The role of credit rating agencies in the process of securitization. When the I-Banks packaged the sub prime debts, they did it in consultation with the rating agencies like Moody's & S & P to deciede the product mix. Essentially, they clubbed Z rated instruments with A++ to get a B. Then added another A++ to get A. Once an instrument is branded A by the rating agency, the selling become easier. This is what made these instruments so popular and the damage so widespread. Bloomberg carried out an extensive article over how the rucus was created and how firms are doing the fire fighting.