In the last few days we have witnessed a lot of turmoil in the global as well as domestic market. Subprime lending is being blamed upon as the major cause for this recent meltdown in the global markets. But there are many people in India who have little understanding of American market and such financial jargon is incomprehensible to them. This piece is meant for the ordinary investor who finds it tough to comprehend the complexities of American market. Sub prime lending is basically about lending to individuals or companies with low credit score i.e. those with poor history of debt re-payment—such loans are also called ‘Ninja’ loans. Why did the financial institutions ventured into this risky territory of subprime lending? Well after the tech bubble burst in the year 2000 the Federal Bank (Indian Equivalent of R.B.I in USA) decreased the interest rates substantially to keep the market flushed with liquidity. As a result there was huge liquidity available in the market which was ultimately diverted towards speculative ventures. Tech bubble in USA was followed by a housing boom. The yield from the treasuries were low so the lenders saw sub prime lending (which is at higher interest rate) for buying houses as highly profitable. Soaring prices of real estate also made them believe that even in case of default loans could be recovered through foreclosure (selling of the mortgaged houses). Japanese economy on the other hand was facing deflation and had resorted to the fiscal mechanism zero interest loans to put itself back on the growth trajectory. Japan became world’s leading lender and many institutions in America gathered loans there at very low interest rates (initially 0% which later was raised to 0.25%) and lent it to sub prime borrowers. Many people began to invest in high-risk bonds and hedge funds with substantial exposure in high-risk credit derivatives and sub prime mortgage companies through leveraging. This was the phase of extreme liquidity and private equity players too made huge money by indulging in leverage buyouts (LBO). There was no dearth of capital which ultimately saw lot of activity on merger and acquisitions front. Many buyouts were made at high premium as there was huge competition for buying stakes which pushed up the costs of takeover to unsustainable levels. As a result huge debt was added for which interest had to be paid. Interest was not a problem till it was low. It was as low as 1% in USA in beginning of 2004. The cheap money ensured that the pace of dealmaking accelerated. In 2006, U.S. LBO firms notched $422 billion in announced deals, dwarfing the record $156 billion in 2005, according to Dealogic, a capital-markets research firm. Last year Blackstone bid $16.4 billion for Free-scale Semiconductor - nearly a 30% premium to its market value, which had already been boosted by takeover talk. After KKR came into the picture, Blackstone had to raise its offer to $17.6 billion to prevail. Paying higher prices meant borrowing more money; as debt levels grew, interest payments absorbed a bigger portion of cash flow, eliminating the margin of safety that made the earlier deals so attractive.2004-05 also saw overheating of real estate prices. What went wrong? Every thing was going fine for the lenders as well as the borrowers until the interest rates were low and real estate

prices were high. However the ghost of inflation began to haunt the central banks all over the world. Excessive liquidity in the region began chasing the commodities, crude oil, metals and bullion. If one can remember well then this was the phase (2003-04), which saw the recovery in commodity and bullion prices. Crude prices too started touching historical levels. Metal prices have skyrocketed since then,largely due to huge demand from China and little capacity expansion in mining activities. This saw the prices of essential and non-essential goods rising much to the discomfort of Federal Reserve. As a measure to curb inflation the apex bank to increase the interest rates. Interest rates in the US rose from 1% in early 2004 to the current 5.25%.

The state of inflation in USA is clearly visible in the statistics of Consumer Price Index (CPI) calculated on the base value of 100 with 1982-84 as base year. We can very well see that there had been considerable rise in inflation.

Strengthening of the yen added to the woes of sub prime lenders. The strengthening of yen makes debt costly and causes unwinding of yencarry trade. This happened in February ’07 and a mild correction was witnessed at that time. Yen carry trade unwinding can have serious implications on the market similar to the LTCM (Long Term Capital Management) collapse of 1999.A sudden rise in value of yen saw the hedge fund (LTCM) losing $4.6 in just four months highlighting the potential risk associated with yen carry trade. The 1994 fund had earlier delivered annualized returns of over 40%.

So sub prime borrowers couldn’t absorb a rise in interest rates, which caused increased default payment of debt. This problem could have been tackled had the mortgages kept their high value intact. But in the last few months the prices have remained more or less flat. Standard and Poor's chief economist, David Wyss, and Moody's's chief economist, Mark Zandi, have forecast 8 percent price drops in the housing market, peak to trough. The mortgage lending companies will have to ultimately realize losses through foreclosure. Countrywide Financial, the nation's largest mortgage lender by volume, reported Thursday that "unprecedented disruptions" in the mortgage market were forcing it to cut way back on the number of loans it was securitizing and selling in the secondary markets. Whole the sub prime mortgage market is not related to buyout financing the problem there sounded alert for the debt investors who now realized the risk they were taking. In mid-July spreads on high yield (which was also high-risk) debt rose sharply making them illiquid. Prices of junk bonds (in the name of companies being acquired) and loans crashed. The big leverage recent deals practically guarantees that default rates on buyout loans will soar from the current rate of less than 1% to atleast their historical average of 5% to 6%, and perhaps a lot higher feel many analysts at the Wall Street. Thus the hedge funds which borrowed heavily to expose themselves to high yield bonds of heavily leveraged companies. This same leverage, which magnified their returns, will now multiply their losses as the value of their assets (bonds they had invested into) takes a beating. Already the biggest fund of Goldman Sachs with assets of over $6 billion has lost over 20%in last six months. Same is the case with funds of Bear Sterns and Lehman Brothers. BNP Paribas has already frozen its three Asset- backed funds. So now the crisis has crossed the Atlantic. So market is likely to see a liquidity squeeze. To tackle this problem central banks of EU ($93billion), Japan, US ($19billion) &Australia will inject billions of dollars in their respective markets. So one can say that from the very beginning subprime mortgage carried the seeds of its own destruction. What could be the implications for India? FIIs could pull out some money from the local market to make up for the losses or reduce exposure to risk in volatile markets. This divesting of the portfolio by FIIs could bring in some selling pressure. Also raising money in international markets through ECBs could become slightly costly for Indian companies. Similarly the Indian companies which have gone on a buying spree in the global market could end up paying higher interest rates for the acquisitions they have made. Tata Steel may see its interest payment rise by 50 basis for its takeover of Corus.The crisis could bring some cheer to the exporters as it may halt strengthening of the rupee against dollar, albeit temporarily, feels former IMF chief economist Raghuram.G.Rajan. Bank scrips could also take a beating at the bourses as investors due to their exposure to collaterised debt obligations (CDO) in credit markets abroad. The underlying asset for the CDO could either be a corporate loan or a subprime mortgage. However Indian banks have admitted that they have little or almost no exposure to US subprime market. In long term banking sector looks promising. To conclude, the Indian growth story remains intact. This was very well reflected in the robust

FY’08Q1 results. Spillover of negative sentiments from American market may temporarily dampen the sentiments of domestic investors but the market in India is poised to test higher levels in the years to come. All’s well with the Indian market.

-- ---- - GAGAN SHARMA
Research Trainee M.S.F.L

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