Subprime Meltdown

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. These loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.
There are many different kinds of subprime mortgages, but the most popular form is “Initial fixed rate mortgages that quickly convert to variable rates”. For example, a "2-28" loan, which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR.
The root of the trouble actually stretches back to 2004. In a battle for market share, the subprime lenders began cutting rates. These low rates weren't very profitable, especially because the Federal Reserve was increasing the lenders' cost of funds at the same time. Their interestrate spread—the key to their profitability—shrank from nearly 6 percentage points in 2003 to just over 3 percentage points by the end of 2005. (Source: Businessweek, March 2, 2007)To resuscitate profits, the subprime lenders started raising their lending rates. Naturally, though, that chased away customers. To keep volumes up the lenders started relaxing their credit criteria. Wall Street encouraged this behavior, too, by bundling the loans into securities that were sold to pension funds and other institutional investors seeking higher returns.
It took a while for the problems to surface because many of the subprime mortgages carried artificially low interest rates during the first few years of the loan. The delinquency rate on subprime mortgages eventually went up Some of this trouble might have been avoided if home prices had continued to climb like they did between 2000 and 2005. In such a scenario, even borrowers who weren't paying the principal loan amount would have built up more equity. That in turn would have made it easier for subprime borrowers to refinance into a new loan with a low interest rate. Since home prices weakened in many parts of US and lenders started becoming more vigilant, such borrowers were not left with much refinancing options.

The impact of the subprime mortgages has been magnified as they started being packaged with innovative financial structures like Collateralized debt obligations (CDOs). CDOs are a type of asset-backed security which gain exposure to the credit of a basket of fixed income assets. These instruments slice the credit risk in different tranches with varying risk and return profiles which in turn are issued as separate intruments. From 2003 to 2006, new issues of CDOs backed by assetbacked and mortgage-backed securities increased exposure to subprime mortgage bonds. The CDO packaging enabled institutions to mix good risk and bad risk debt all in one pot and label it as good risk. Therefore the financial institutions earned a higher rate of return on what seemed like a relatively low risk CDO package that was priced in the market price as low risk debt upon which hedge funds such as Bear Stearns leveraged to the hilt.

Hedge funds deploy leverage to enhance their exposure to markets. When things are moving in the right direction this results in phenomenal profits. However if they are caught in the wrong direction, they may end up eroding their entire capital. The LTCM collapse in 1997 was fallout of the excessive leverage taken by the fund. This is what happened with Two of Bear Stearns Hedge funds recently, which placed highly leveraged bets on packages of subprime mortgage derivative products. When the value and credit worthiness of these bond packages was cut due to the subprime defaults, these funds started received calls from the banks which had provided them funds to leverage their bets in the subprime market. In order to meet their commitment towards these banks, they sold a part of their portfolio in an illiquid market. The illiquidity ate into their portfolio as their own selling led to a further fall in prices. The effect of this was it virtually wiped out the total value of the funds that had previously been rated as low risk.

Meanwhile, the $11 billion Raptor Global Fund posted a one-month loss of 9%, while two hedge funds run by Australia's Macquarie Bank were off 25% this year (Source: Businessweek, August 13, 2007). And Sowood Capital Management has already started bleeding.

Subprime woes have moved far beyond the mortgage industry. Already, at least five hedge funds have blown up. The latest worry is that a recent slump in the markets for corporate loans and junk bonds will deepen, jeopardizing the financing of leveraged buyouts, a big profit driver for investment banks. What's more, fears are growing that banks may be on the hook for some of the $300 billion in loan commitments they've made for buyouts already in the pipeline.


Impact on the equity markets
As the subprime woes continue, the stocks of the banks, funds and other financial institutions having exposures to such assets plummet leading to a fall in the broad markets. Also, as the subprime markets go down, the hedge funds receive calls by the banks to meet their margin commitments forcing the hedge funds to liquidate their portfolio. This derivative ripple affect results in selling off emerging market equity portfolios. As liquidity moves out to safer assets, riskier assets like emerging markets start tumbling down.

Outlook on the Indian Markets

In the short term, the markets may correct if liquidity flows out and may consolidate between 14000 – 14500 levels. The markets valuations have been stretched for sometime and a correction is expected. We remain cautious, as the following factors remain a cause of concern
     * Stretched equity market valuations - ahead of fundamentals
    * High leverage in the market
    * Increase in input costs as demand exceeds supply
    * Appreciation in INR – concern for exporters of goods and services
    * Rising crude oil prices
    * CRR hike – cost for the banks

However, the fundamentals of the economy remain strong as evidenced by:
    * 30% Q1 profitability growth (Source: Internal Analysis)
    * Interest rates seems to have peaked out
    * Inflation has come down below 4.5% (Source: Office of     economic Advisor, Ministry of Commenrce & Industry, GOI)
    * Satisfactory monsoons

The Indian stock markets remain exposed to the global liquidity pressures but fundamentally, being an economy fuelled by internal consumption demand, the economy is less vulnerable to the global economic situation. Also, in terms of valuations, the Indian markets, which were trading at a significant premium to its South East Asian counterparts, has come back to parity. The long term strength of the market is intact and a further correction from these levels would be a good opportunity to accumulate for the long term.

Source: ICICI Prudential Asset Management