Sub-prime is a word that is increasingly prevalent in banker’s nightmares from New York to London to Tokyo. Over the past couple of weeks the random walk of markets has been converted into a violent lurching. The contagion has spread from the US housing market to the broader credit, equity and FX markets across the globe. Indian markets have also reacted and are likely to be caught in the coming storm.Money for nothing
The root of this crisis lies in the booming US housing market of 2001-05. Interest rate cuts following the dot-com bust and 9/11 (Fed funds rate went from 3.5% in August 2001 to a low of 1% in June 2003) encouraged borrowing to buy houses. As house prices soared, more and more buyers rushed in to cash in on the great opportunity. Cheap borrowing and rocketing house prices made it a “no-brainer” trade. Helping people get on the bandwagon were eager brokers who earned commissions on the loans they sold and even more eager lenders who sold these loans to Wall Street banks. Prime borrowers (those who have sufficient income and assets to pay back the loan) weren’t enough. Alt-A loans (where the borrower self-certifies his/her income and assets), sub-prime loans (made to people with poor credit history) and finally NINJA loans (made to people with No Income, No Job and no Assets) fanned the fire in the housing market. Wall Street banks employed alchemists (formally known as structuring desks) who ‘securitized’ these loans before selling on to end investors such as hedge funds.
The Alchemists
Structuring desks pool together hundreds of home loans and wield sophisticated mathematical scalpels to slice and dice the portfolio risk to create multiple securities from it. Financial alchemy is in creating securities rated safer than the underlying portfolio and which pay a higher return compared to similarly rated assets. The process can create multiple securities with tailormade risk-return profiles (See box).
The alchemy of securitization is easier to understand with a simple example:
Combine many loans into a portfolio worth Rs. 100. Then split this portfolio into two pieces of Rs. 10 and Rs. 90. The first piece takes any losses upto Rs. 10 (the so-called ‘equity tranche’) beyond which the second piece gets affected (the ‘senior tranche’). It is obvious that the first piece is riskier than the second. If the portfolio suffers a loss of Rs. 5, the equity tranche loses 50% (5 out of 10) of its value but the senior tranche remains unaffected. The equity tranche will pay a higher rate of return to compensate for the higher risk and is suitable for a risk seeking investor.
Rather than splitting the portfolio into only two tranches, multiple tranches with differing risk-return profiles can be created catering to a range of investors - from racy hedge funds to staid pension funds.
Free lunch
Rising house prices and fixed interest rates on loans for the first couple of years led to few borrowers defaulting. This meant that the expected loss on securities was less than forecast. And in a low interest rate environment, investors just couldn’t get enough of the juicy returns that these securities offered. They asked the banks for more, and the banks in turn asked the lenders to give out more loans. More borrowers meant more demand for houses pushing the prices further up. A virtuous cycle was created with everyone making money.
Party over
However, as the Federal Reserve began to increase interest rates in response to rising inflationary pressures and the fixed rates on loans converted to floating (loans were given with low fixed rates to attract borrowers but converted to floating after 1-2 years), borrowers suddenly found that they couldn’t pay the higher monthly installment. Initially they sold houses to lock-in whatever profit they had made. But as selling intensified and newly constructed houses came into the market, prices started to go down. The bet had gone wrong.
Perfect storm
But why should Mr. John Smith defaulting on his mortgage cause such panic in world markets? The chain from an individual’s mortgage to the end investor has been explained above. However, we’ve neglected to take into account the additional leverage built into the system. Not content with the slightly higher return earned on the security relative to its risk rating, investors and funds borrowed money to enhance these returns further.
Leverage makes for intoxicating returns as long as the bet doesn’t go sour. If it does, the hangover is usually severe. For example, a leverage of 9-to-1 can result in the investor being wiped out completely on a loss of only 10%. Even a much smaller loss can cause it to get into trouble. For example, a 2% loss on the security translates into a 20% loss for a fund levered 9 times.
When a leveraged fund makes losses, its creditors ask for more money as collateral to keep the leverage at the same level. Apart from the creditors’ demand for cash, the investors in the fund also smell trouble and ask for their money back. This double whammy means that the fund becomes a forced seller unless it has ample cash reserves. As more and more funds turn forced sellers, prices of these securities get driven down further, thus intensifying the demand of creditors and investors. The fund might sell other assets that it owns to meet the demand for cash. This leads to a spillover into other previously uncorrelated markets. Leveraged investors in these markets need to stump up cash as well as prices of what they own start falling. This leads to a vicious cycle of selling across all asset classes and geographies.
This is the ‘perfect storm’ scenario that the markets are dreading. High volatility in global markets over the last few days seems to indicate that a storm is materializing.
India invincible?
At first glance, the impact of a global sell-off should be limited given total FII investments account for only about 6% of Indian equity market capitalization. This makes the current high correlation between Indian and global markets somewhat inexplicable.
But prices are determined at the margin. FIIs looking to raise cash to meet creditor and investor demand will start to sell. Even if they do not require cash, they would seek to lock-in some of the gains made in the last few years to balance the losses sustained in other parts of their portfolio. A sustained selling by FIIs will lead to a sharp drop even if fundamentals remain intact. The real danger is that fundamentals do not remain intact. The increased likelihood of a US recession following the housing bust is likely to lead to a slowing of the global economy. This would take the shine off the India story.
As the global storm gathers strength, investors would be well advised to go into cash. Risking and losing all your winnings on one turn of pitch-and-toss may make you a man but rarely will it make you rich.
Also by Shashank
- Chindia - Approach Matters - October 30th, 2006
Shashank: Very well written that made it simple to understand. Thanks! What next?
Sub-prime mortgage (which is primarily covered here) is only a part of the picture. The sub=prime lending circus is even bigger (and which has cost the CEOs of Citi Group and Merrill Lynch their jobs recently) and uglier. Even orthodox investment firms like Bear and Stearn have been caught in it.
And another issue that has been surfacing of late is the crunch in the “Home improvement” sector. Now that the prices of houses have come down drastically, these huge chains like Home depot, Lowe’s etc. have started to feel the heat.