The Hindu Business Line : On market turbulence and its genesis

The easy liquidity policy — with US Fed rates touching 40-plus year lows about four years ago has led to a steep rise in property prices in the US markets. In several regions, prices were reckoned to be akin to bubble-like territory even early this year. The low-interest rate policy led to a boom in mortgage financing. As lenders exhausted high-quality clients, they gradually started moving down the credit curve of borrowers. This gave rise to sizeable loans to borrowers who figured low on credit quality. The boom in these loans — has been on an unprecedented scale.

What led to a change in the US housing market and its financiers?

The home buying spurred by low interest rates led to prices going way of out of line with realistic levels. The sharp price rise had an in-built trigger to snowball into a problem at some stage unless the period of extraordinarily low interest rates sustained. This was never going to be the case.

As the US Federal Reserve moved to raise rates — there were 17 successive hikes of 25 basis points each, from June 2004 to June 2006 leading to the Fed Rate moving from a low of 1 per cent to 5.25 per cent — the impending crisis in US property markets got fast tracked.

What has happened in the sub-prime segment?

As interest rates rose, so did payment obligations (EMIs or their equivalent in the US) linked to variable rates and this started account for a larger proportion of income, leaving borrowers vulnerable. As US consumers are also highly leveraged, the rising payment obligations make things more difficult. This has triggered defaults on a rising scale, especially at the lower end of the credit curve. What is the linkage to movements in the financial markets?

Lenders who provided sub-prime loans packaged them together and sold it to investors as securitised assets. As such loans and risk appetite to buy securitised assets based on such loan pools increased, more exotic versions were added. Investors in such assets also included hedge finds that are usually leveraged significantly. (They also borrow and invest that money, too, over and above the capital to enhance returns).

It is this structure that gained critical mass that has become the root of the problems in the financial markets. Hedge finds that have taken a hit in sub-prime need to unwind exposures in other asset classes to compensate and ensure that they stay in tune with the fund mandate.

What has happened in the market for these assets?

There has been a significant decline in liquidity. Trading levels for some asset-backed bonds have declined dramatically and these include bonds with AA or AAA ratings (high investment grade). There are few buyers even for such assets. The lack of liquidity has ensured that valuation and ratings have been left at uncertain levels and without any meaningful linkage. It is even harder to trade risky high-yield bonds, junk bonds and loans for borrowers with high debt. As this is also the vacation season, liquidity has been further affected in these markets.

(Excerpted from “A note on Markets” by Sundaram BNP Paribas Mutual Fund and BNP Paribas Investment Partners)

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