Pick up any business daily, switch on any business channel or speak to anyone who has even a remote connection to financial world ... 9 out of 10 you would hear that dreaded phrase before you hear anything else ! Ironically, very few of us really understand what it really means and how far the same can or can not effect the global markets. Its a US specific phenomenon and even the average US investor doesnt understand the intricacies of the same.
So, in a scenario where the basics are hazy to such an extent, what should one do ? Right now, the fear is what is guiding everyone, more or less. On a very basic scale, lets try to figure out what subprime means (and i admit that I know little about it myself ! ) ....
Property owners who want to mortgage the same to raise funds, are classified into two categories, basically. One, those whose credit rating is excellent and are thus classified as prime borrowers. Rest of them, with a credit rating that may be less than excellent to below par, are classified as subprime borrowers. Both categories need funds ( thats how the consumption-led US economy runs ... spend more than you earn, consume more than you can afford) ... and hence mortgages. Prime borrowers are more secure in terms of repayments etc and are thus offered lower rates of interest. The second category, with higher probable risk attached, are willing to pay higher rates of interest for the mortgage ... and hence, the higher risk is offset by higher rates of return. As long as the borrowers keep paying the installments on their loans, everyone is happy. Trouble starts when there are defaults in repayments, which can happen when rates of interest rise from what they were when the mortgage was raised.
Rising rates increase the installments and hence possible delinquency ... which can lead to foreclosure, meaning the lender takes possession of the mortgaged asset. This is where things become complicated ... foreclosure means the property is taken over by the lender, which is usually a house against which the loan was raised. As the US housing market is facing a decline over the recent past, two things can happen ... either, the current market value of the asset possessed is lower than the current dues which results in a loss on a marked-to-market basis. Or, and more importantly what we are seeing now, the property isnt easily saleable due to the slump and the lenders are saddled with an asset that at present is hard to value as to current market price.
Now, the hedge funds and banks that have made very good gains over the past on the same subprime mortgages due to higher rates of return are now facing delinquencies. This will certainly result in some losses as we are seeing from various reports ... however, my personal view is that such losses are a small part overall in percentage terms. Yes, we will see certain schemes of hedge funds report losses and even closure ... but, that doesnt mean the entire hedge fund will collapse. A Bear Stearns that had an asset base of USD 350 billion as on Nov 2006 wont sink with a 5-10 billion loss, will it ?
The reason why everyone is clamoring for Fed to cut rates is that it may result in the subprime borrowers' installments getting lower to that extent and hence a lower possibility of defaults, which would mean more breathing space for such riskier assets. However, the basic nature of such assets wont change .... they would still remain a higher risk.
Hedge funds and banks that hold such mortgages own them as a part of their overall portfolio of investments ... those schemes that were primarily created to take advantage of subprime market would certainly see higher losses. However, as far as my understanding goes, one schemes losses wont effect another scheme that may not have subprime exposure or has a very limited exposure.
As I suggested earlier, fear is what is guiding most right now .... and no doubt, there will be pain to go through to an extent, which is understandable as the same funds enjoyed the fruits of above average returns as well on the same assets in the past.
So, in a scenario where the basics are hazy to such an extent, what should one do ? Right now, the fear is what is guiding everyone, more or less. On a very basic scale, lets try to figure out what subprime means (and i admit that I know little about it myself ! ) ....
Property owners who want to mortgage the same to raise funds, are classified into two categories, basically. One, those whose credit rating is excellent and are thus classified as prime borrowers. Rest of them, with a credit rating that may be less than excellent to below par, are classified as subprime borrowers. Both categories need funds ( thats how the consumption-led US economy runs ... spend more than you earn, consume more than you can afford) ... and hence mortgages. Prime borrowers are more secure in terms of repayments etc and are thus offered lower rates of interest. The second category, with higher probable risk attached, are willing to pay higher rates of interest for the mortgage ... and hence, the higher risk is offset by higher rates of return. As long as the borrowers keep paying the installments on their loans, everyone is happy. Trouble starts when there are defaults in repayments, which can happen when rates of interest rise from what they were when the mortgage was raised.
Rising rates increase the installments and hence possible delinquency ... which can lead to foreclosure, meaning the lender takes possession of the mortgaged asset. This is where things become complicated ... foreclosure means the property is taken over by the lender, which is usually a house against which the loan was raised. As the US housing market is facing a decline over the recent past, two things can happen ... either, the current market value of the asset possessed is lower than the current dues which results in a loss on a marked-to-market basis. Or, and more importantly what we are seeing now, the property isnt easily saleable due to the slump and the lenders are saddled with an asset that at present is hard to value as to current market price.
Now, the hedge funds and banks that have made very good gains over the past on the same subprime mortgages due to higher rates of return are now facing delinquencies. This will certainly result in some losses as we are seeing from various reports ... however, my personal view is that such losses are a small part overall in percentage terms. Yes, we will see certain schemes of hedge funds report losses and even closure ... but, that doesnt mean the entire hedge fund will collapse. A Bear Stearns that had an asset base of USD 350 billion as on Nov 2006 wont sink with a 5-10 billion loss, will it ?
The reason why everyone is clamoring for Fed to cut rates is that it may result in the subprime borrowers' installments getting lower to that extent and hence a lower possibility of defaults, which would mean more breathing space for such riskier assets. However, the basic nature of such assets wont change .... they would still remain a higher risk.
Hedge funds and banks that hold such mortgages own them as a part of their overall portfolio of investments ... those schemes that were primarily created to take advantage of subprime market would certainly see higher losses. However, as far as my understanding goes, one schemes losses wont effect another scheme that may not have subprime exposure or has a very limited exposure.
As I suggested earlier, fear is what is guiding most right now .... and no doubt, there will be pain to go through to an extent, which is understandable as the same funds enjoyed the fruits of above average returns as well on the same assets in the past.
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