How is your risk appetite today

Indian Express, 2 August 2007

Indian stock markets have fallen sharply in recent days in line with the sharp volatility seen in global markets. The source of trouble this time is news from the US housing market. The mortgate market for poor quality home loans -- the "sub-prime" market is in trouble. How does the US sub-prime market hit the US economy, the US stock market and global financial markets, including India, Ila Patnaik explains.

What is the US "sub-prime" market?

For many years, the US saw a boom in the housing market. Individuals with high salaries and the ability to pay high EMIs availed of "prime" loans. In addition, there arose a "sub-prime market", where home loans were given to people with a poor abiilty to repay. Financial companies pushed loans in which the customer had very low repayments in the short term (e.g. for the first two years), but after that the EMI would rise sharply. Many times the people to whom such loans were given would default when the rise in EMI came.

How did giving loans to people with a poor ability to repay make good business sense?

The higher risk of default meant that the interest rates charged on these loans were higher. Further, clever financial engineering where the loan basket was "securitised" : cut up into less risky and more risky assets and sold to lenders with different risk appetites, allowed lenders to make profits.

Why did the "sub-prime" business model run into trouble?

From 2004 to 2006 US interest rates rose sharply. This led to an upsurge of defaults on home loans from a variety of households who found the higher interest burden unpayable. When a home loan defaults, the bank repossesses the house and sells it on the market. But if the value of the house falls during this time, as has been happening in the US, the lender is unable to recover his loan. These financial companies and those who fund them run into trouble and may have to go bank-rupt.

What is the most recent news on the "sub-prime" market?

Most facts about the sub-prime market were becoming known in 2006. The consensus view at the time was that while the outlook for housing is bad, and while sub-prime loans would do badly, these difficulties are not big enough to shake the overall financial market. Hence, financial markets shrugged off the problems and asset prices continued to be high.

This perception has changed in recent weeks as markets have seen dropping home prices and continued worsening of defaults amongst sub-prime loans. High-profile failures of financial firms working in the sub-prime mortgage market has shaken the confidence of people that things will be fine. People are willing to take less risk for the same returns today. This is know as "re-pricing" risk.

What are the other signs that a "re-pricing" of risk is going on?

In recent weeks, there has been a significant change in the risk perception in the US bond market. When a bond is issued by anyone other than the government, it commands a "credit risk premium" - it has to pay a higher interest because of the risk of default. Credit risk premia on the US corporate bond market have risen sharply. Hightened risk perception is also seen in US stock prices, measured by the "VIX" that measures expected volatility of the S&P 500. This has lead to a "re-pricing" of risk on all financial assets.

What could be the impact of the above volatility in US stock markets on Indian stock markets? The link to emerging markets and to India lies in the fact that there is a close, but not perfect, relationship between the risk premium required for corporate bonds in the US and the risk premium required for purchasing emerging market stocks. Both reflect a common underlying appetite for risk amongst global investors. Events in the US have perturbed global investors and they are now demanding a higher premium in return for bearing any kind of risk, including that of stocks of emerging market economies including India.

When the emerging markets risk premium goes up, prices of emerging markets assets go down. This includes shares, bonds, real estate, etc. Hence, we are seeing lower prices in India for shares, corporate bonds, and real estate.

How might this story shape up in the days to come?

A good scenario envisages the equilibriating responses of markets. Global currency markets have been playing a valuable role in achieving an equilibrium. The US dollar has been losing ground, thus making US assets more attractive. Lower prices for US corporate bonds and houses will make them attractive to investors once again. If a serious downturn emerges, the US Fed can cut interest rates.

A gloomy scenario involves a loss of confidence on the part of global investors in the engine of global economic growth. The ability of the US Fed to cut interest rates is limited by inflation in the US which has remained above the Fed's target of roughly 2%. Many assets worldwide - ranging from US housing to Chinese shares - are priced at very high valuations, and have a lot of headroom for continued price declines. It could be choppy times ahead.

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