Introduction:
Of late, we see many articles related to US sub-prime mortgage crisis in business magazines, web sites etc. The India Street attempts to discover the background of this crisis and its effect on Indian stock markets.
Overview of sub-prime mortgage industry:
Before we understand the crisis, let us first define what is mortgage and sub-prime mortgage.
Mortgage: In simple terms, it is a “conditional” conveyance of property as security for the repayment of a loan.
Sub-prime Mortgage: It means offering loans to borrowers who do not qualify for them at market interest rates due to their deficient or poor credit history. Since this involves risk of non-payment by the client, it is usually offered at a higher interest rate.
Sub-prime lending may be utilized for sub-prime mortgages (few home loans), sub-prime car loans, sub-prime credit cards etc. Subprime mortgages totalled $600 billion in 2006, accounting for about one-fifth of the US home loan market. Some of the sub-prime mortgages include:
- interest-only mortgages, which allow borrowers to pay only interest for a period of time
- “pick a payment” loans, for which borrowers choose their monthly payment
- initial fixed rate mortgages that can be converted to variable rates
Potential sub-prime borrowers may comprise of financially troubled people i.e. those who lost jobs, those with a history of previous debts, those who have had marital problems or those who had unexpected medical conditions. Sub-prime lenders take a higher degree of risk; by increasing the interest rates they manage to offset the risk to an extent.
The current sub-prime mortgage crisis in US:
The US real estate industry had a boom between 2001 and 2005 as property prices reached historic highs on account of low interest rates, price-to-rent ratios and other factors. When property prices began to fall due to saturation or lack of demand, the owners had to face mortgage loan which was higher compared to property value. The collapse of the US market had a direct impact on housing values, mortgage industry, real estate companies, hedge funds etc. (A hedge fund is an investment fund charging a performance fee and typically open to only a limited range of investors; unlike mutual funds and pension funds, hedge funds are not usually regulated by Securities Exchange Commission.)
In late 2006, several US sub-prime mortgage companies had to close down due to losses. New Century Financial Corporation had to file for banktrupcy. Some companies were accused for actively encouraging fraudulent income inflation on loan applications. This led to collapse of stock prices for many companies in sub-prime mortgage industry, notably for some large lenders like Countrywide Financial and Washington Mutual.
Recent news on sub-prime mortgage industry:
- On June 20, 2007, Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds that were involved in securities backed by subprime loans. The two funds are now reported to be essentially worthless
- American Home Mortgage Investment Corporation filed Chapter 11 bankruptcy on August 6, 2007, after a layoff of its employees the week before
- On August 8, 2007, Mortgage Guaranty Insurance Corporation announced it would discontinue its purchase of Radian Group after suffering a $ 1 billion loss of its investment in Credit-Based Asset Servicing and Securitization. C-BASS is seeking to restructure its financing. The MGIC-Radian transaction would have been a $4.9 billion deal.
- on August 9, French bank BNP Paribas stopped valueing three of its funds and suspended all withdrawals by investors after United States sub-prime mortgage woes had caused "a complete evaporation of liquidity”
- Accredited Home Lenders reported on August 10 that the company expected to see up to a $60 million loss for the first quarter 2007
- Goldman Sachs' $8 billion Global Alpha hedge fund, its largest, reportedly lost 26% in 2007
- Citigroup has reported taking $700 million in losses in its credit business in July and August 2007
Impact of the crisis on stock markets:
Ideally, only the companies belonging to the US real estate sector or sub-prime mortgage industry should have been affected. But, the stock markets all over the world, right from From New York to Tokyo, were sliding and it was reported in media that the reason for the ‘meltdown’ is US sub-prime mortgage crisis.
Is this really true for Indian markets? This is what Securities and Exchange Board of India (SEBI) Chief, M Domodaran, had to say (Source: oneindia.in)
“SEBI Chairman M Damdodaran today discounted the impact of the United States sub-prime loan market troubles impacting on the Indian stock exchanges, saying that stock prices are a determinent of several factors operating on a given day.
''He will be a bold man who assumes that stock prices are a resultant of one single factor. At the end of the day the price of a stock is determined by the demand and supply of that stock," Mr Damodaran told newspersons on the sidelines of a function here.
A fall in the indices cannot be linked to one factor especially if that is external, he said.
''It would be an oversimplification if the fall in the stock market in India is linked only to sub-prime mortgage crisis in the US,'' Mr Damodaran said.”
It is quite clear from the above that US sub-prime mortgage crisis has nothing to do with Indian stock markets.
Previous crisis situations in Indian stock markets:
This is not the first time we have had a ‘crisis’ or a huge fall in index. We saw a few previously. Let us review some of them, starting April 2003 (since beginning of the current bull market.)
April 10, 2003: The Nifty had lost 4.24% and the main reason attributed to it was “A weaker than expected performance by technology leader Infosys, coupled with gloomier profit guidance for the year ahead”. Infosys lost 27% and Mastek lost 50% in a single trading session. Many software companies, including HCL Technologies, Satyam Computers etc. had lost more than 10%.
If one year hasn’t been fruitful, next year could be. Also, it is not necessary that because Infosys didn’t perform well, other companies should also follow the suit. So this was clearly a case of overreaction by the entire market.
May 14 and May 17, 2004: Often referred to as ‘Black Friday’ and ‘Black Monday’, the Nifty had lost 7.87% and 12.24% respectively (nearly 19% fall in two days).
“THE Day After... ..! It was carnage on the bourses. Stock prices fell like ninepins on Friday as fears of a possible slowdown in economic reforms and disinvestment, jolted the market.”
“THE spectre of "market-unfriendly" Left ideology having an overwhelming influence on economic policy-making at the Centre drove equity investors into a selling frenzy that saw the BSE Sensex fall 842 points before recovering about 300 points in late trade.
The selling fury triggered, for the first time, index-based circuit filters that halted trading twice during the day, reducing trading time by three hours. Today's fall also eroded more than Rs 2 lakh crore in value from stocks.”
The Nifty has managed to close at 4621 on July 24, 2007. On May 17, 2004 it closed at 1389. This gives a gain of 333%. It should be noted that there hasn’t been a change in the central government or political scenario so far.
Between May and June 2006:
Between May 10, 2006 and June 15, 2006 there were as many as 6 trading sessions that lost 4% in Nifty (May 15, 18, 19, 22, June 8 and June 13). During this period the index had lost nearly 30%.
“In yet another Black Monday, weak signals from global bourses, declining metal prices, and heavy selling by foreign funds sent domestic stocks into a tailspin, with the benchmark BSE-30 Sensex sliding 462.91 points (3.77 per cent) - its third biggest fall ever - to close at 11,822.20 points…The NSE's S&P CNX Nifty index lost 147 points (4.03 per cent) to close at 3,502.95.”
“Dalal Street experienced its worst single day crash on Thursday, as an ambiguous Government circular on taxing investment gains prompted foreign funds to book profits, knocking the bottom off the jittery stock market.”
“The hammering on Dalal Street continued on Friday, with exchanges and broking firms dumping stocks due to lack of margins. Market-unfriendly statements by Left leaders on reforms and taxing of foreign funds helped despatch the bellwether BSE-30 down 452.82 points, or 3.98 per cent, to below 11,000. The S&P Nifty Index dropped 142 points or 4.19 per cent”
“It was as if a tornado of the Twister mould had ripped the stuffing out of India's capital market in the first couple of trading hours on Monday.
By 11.45 a.m., trading in the country's premier stock exchanges, the BSE and the NSE, lay in ruins as the Sensex sank by 1,111.7 points from Friday's close of 10,938 and the NSE's S&P Nifty plunged by 350 points to 2,896.40, before trading was suspended for an hour. Having triggered the 10 per cent lower circuit, it took a one-hour suspension of trading mid-day to stem the panic and arrest what was otherwise turning out to be a freefall with no visible break to cushion the plunging indices.”
“There was no respite for the stock market on Thursday with frontline indices sinking to mid-January levels on lack of buying support, mutual fund redemptions and tightening global liquidity. NSE's S&P CNX Nifty Index lost 136.1 points or 4.76 per cent to 2,724.35 points. “we expect an intermediate rally to commence in the third quarter of 2006, which could take the Sensex to 14.7k by June 2007," Morgan Stanley said in a note to investors.”
It was freefall for the stock markets on Tuesday with the benchmark BSE-30 Sensex wiping out all gains of 2006 and ending at a six-month low of 9,062.65 points, down 413.50 points or 4.36 per cent from Monday.
Panic selling by high net worth individuals and heavy offloading by mutual funds to meet redemptions drove stocks down. This is the lowest the Sensex has ended at since December 8, 2005.
It can be seen that each time the indices have fallen, a different reason has been attributed.
Conclusion:
The media, be it print or electronic, always speculate. In stock markets, ups and downs are always a part of the price action. Read my earlier interview here. Investors have to visualize it as a normal business and try to find investing/trading opportunities during the days when index falls considerably.