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‘Subprime’ woes – What should investors do?

This article was posted on Aug 12, 2007 and is filed under Press Releases

      Yen Carry Trade, Rupee Appreciation, Crude Oil Price, Inflation, Leveraged          Positions, Negative Sentiments, Scams, and Possible Slowdown in Corporate Earnings Growth were some of the favorite fears and reasons when stock markets took a beating. This time it’s a new one “Sub Prime”. There is always a new fear or reason that inflicts the markets and creates some sort of confusion and panic on what to expect next or do next.

So what is this sub prime?

Subprime Lending, is a term that refers to the practice of making loans to borrowers who do not qualify for normal market interest rates because of problems with their credit history. These loans are generally considered risky because of the lethal combination of high interest rates, bad credit history and lack of resources to pay off the loans over a longer timeframe. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others.

Subprime Mortgages are bought by financial institutions, structured in the form of bonds and then sold of to investors at a much higher rate than normal corporate bonds. Hedge funds at the other end are always ready to oblige buying the riskiest of these assets, even with leverage. Aren’t they always looking for something exotic? When the underlying loans go bust, is when these bonds and their investors land in trouble. Similar situation was witnessed in case of 2 failed hedge funds of Bear Stearns where the loss was more than 90%. The leverage that is used by hedge funds is often the root cause of failure of these institutions. Does someone remember the Long Term Capital Management collapse in 1997? It was one of the events that underscores the point that a high IQ or a Nobel Prize Winning IQ does not ensure success in the investment industry.

How does Sub Prime affect the Indian Stock Market?

Fundamentally there is no impact on GDP growth or Indian companies. Infact the growth for the last quarter excluding a few sectors has been around 30 %. At the same time interest rates seem to have peaked out and inflation seems to be well under control. However the markets also correct if the RBI Governor sneezes during RBI Monetary policy meetings, which brings me to an important aspect called “Sentiment”.

When the going gets bad in the sub-prime market, the sentiment can change based on how emerging markets are viewed as a whole in terms of risk. In a leveraged sub-prime market, hedge funds will receive margin calls if their investments in the sub-prime market go down. This in turn can force hedge funds to liquidate their assets in local and emerging markets, which will put some downward pressure on the Indian stock market, which we have already witnessed. Whether this downward pressure on our markets will continue for some more time is difficult to say as sentiments can change very fast.

What should an investor do in such a scenario?

  1. For investors who have no exposure to equity, such falls present good opportunity to enter the markets in a staggered manner. The choice of stocks and sectors and hence a combination of top-down and bottom-up kind of stock picking is paramount.
  2. Investors who have reasonable exposure to equity in alignment with their risk profile but with a longish time horizon of 5-10 years need not panic and press the Sell button. However a review of their overall asset allocation is warranted and if this has resulted in the equity component going up, then you could look at reallocating some portion to debt through Fixed Maturity Plans. (Also read – Why FMPs are more lucrative than Bank FDs?)
  3. If you need money for funding any of your goals in the next one year or someone has a shorter time horizon, then it is important to immediately review your portfolio and decide whether you need to lighten your equity exposure.

Time and again these kinds of events will affect the sentiments of the market and will in turn present opportunities to enter the market. However it takes a lot of conviction to enter stocks during a correction and its not just the average investor but also fund managers who lose out on such opportunities.

It is very difficult to decipher anything meaningful out of such events. However people who invested during the last two major corrective phases are sitting on tidy profits in a very short period of time. Well the next corrective phase might be the one that we are in now.

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