Sub prime woes ...

At the heart of the turmoil in financial markets, central bankers believe, is an information problem that has magnified the consequences of what appears to be a credit problem in securities backed by US subprime mortgages.

Underlying credit quality remains good in most of the US economy – including the prime mortgage market. Policymakers believe that this should limit the extent of any pull-back from lending.

They believe that markets are paralysed by lack of information as to the ultimate size and distribution of losses – which has contributed to a sudden drying up of liquidity in the three-month interbank and commercial paper markets.

The information problem has two components. First, investors do not know where the losses from subprime – which Ben Bernanke, the US Federal Reserve chairman, suggested last month could be up to $100bn – lie.

Second, they have lost confidence in their ability to value complex structured credit products that include some exposure to subprime bundled up with exposure to other underlying assets.

“Investors are facing enormous uncertainty on the likely size and distribution of financial losses, on the credit quality of their assets, and on counterparty risk,” said Marco Annunziata, chief economist of Unicredit, the banking group.

In principle at least, investors can overcome the problem of not knowing where subprime losses lie by investing in a diversified pool of credits. A few of these investments may turn sour, but the portfolio as a whole should not.

However, the uncertainty over where losses lie may be compounded by what economists call information asymmetries and adverse selection. Banks or other entities sitting on large losses may seek funding even at unattractive rates in current market conditions. Those in better shape may hold back, hoping for better times.

If this is the case, it would be unwise to lend to even a broad range of institutions now coming to market.

This information problem should abate over time, as banks, hedge funds and other institutions mark their investments to market and are forced to reveal the size of their losses.

However, Peter Hooper, chief economist at Deutsche Bank Securities, said “it is going to take a good while for this uncertainty to work its way through the system”.

The loss of confidence in valuation may take longer to fix. If investors do not know how to value a security, the classic “price discovery” process by which sellers and buyers settle on a new equilibrium price may not function. Markets – for instance for complex structured derivatives and some asset-backed securities – could remain closed for some time.

Ultimately the complexity problem too is solvable.

The financial institutions that created these products in the first place will break up the products into separate income streams investors can understand and can price: subprime, non-subprime mortgages, auto loans, and credit card receipts.

The dilemma for central banks is, if an information problem really is at the core of the turmoil, there is not much they can do to address it directly.

Jean-Claude Trichet, president of the European Central Bank, and Axel Weber, president of the Bundesbank, tried to give reassurance about the exposure of the European banking system, but to little effect.

Central banks on both sides of the Atlantic are likely to try to hold to the position that they should simply keep overnight liquidity flowing.

There is a danger rate cuts could aggravate the information problem, by suggesting that central banks have more negative information than the markets possess. But if markets remain dysfunctional for a long period the case for rate cuts will mount, because they would help offset its consequences for the real economy.

Thanks for a detailed insight into the US sub-prime woes. Today's TOI newspaper also has a very insightful account of what this situation really means. As I read more on it, I fear that the problem is deep rooted and will unfold its ugly head as time goes on.
Paresh

Explaining Sub Prime woes

Consider you are going to buy a property for 120 rupees. You were to fund it with Rs 20 of your money and for the remaining Rs100 you were to take a loan from bank A. The bank gave u the loan knowing that your income is Rs 4 per month. They were charging a interest rate of 10 % p.a that works out to Rs10. The tenure of the loan was 10 years. So the total of principal and interest would come to Rs 200 over 10 years which means Rs 20 per year. This resulted in you paying Rs 1.66 per month as your installment. Now that was okay considering your income per month was Rs 4. Assuming that the bank had only one customer and that is you. They would show in their balancesheet that they have given u Rs100 and are earning 20 rupees cash flow every year for the same.
Now consider what would happen if the price of the underlying went frorm 120 to 100. over a three year period. So now w r in the fourth year and the value of the property is now Rs100. The bank now knows that it is trapped. If u default on the loans for any reason they will have recovered only 60 rupees from you. ( this is the yearly outflow of rs 20 multiplied by 3 years ). The bank ha survived its operational expenses with the help of Rs 20 that u paid every year. The property is now worth only Rs100. The catch comes in here, and understand it properly. At the start of the 1st year when u went to them for loan they had Rs100. Now at the start of the fourth year they have just 1 property worth 100. Now the bank needs to function doesn’t it?. So from where is it going to pay for its expenses ( staff, rent etc ). They only have a property worth Rs 100. Now a buyer will not be willing to pay the bank Rs 100 for the property because it knows that the bank is desperate as it needs the money and that will drive the price of the property down further. The price at the end of the fourth year will go down to Rs 80. Assuming that the bank survived the year with the central banks help ( read lossening of rates, as happened yesterday). But you see it may see another year but ultimately it will have to offload the property in the markets the faster one does it ( the bank admitting its mistake ) the better off it is. But if they do so then they will have to show major loss I the year they do it Now no bank is ready to do it. Till we see major lossess being reported by these hedge funds the problems going to be there. Good medicine for any ailment they say is bitter

As the multitiered loans that have gone bad in the US are written off, the world markets will begin to hopefully be less volatile than the last nine months. Just as these events were very difficult to predict, the end of the subprime crisis/recession will also be unpredictable. If one is positioned for the long term in very high quality equities and keep properly diversified, then there will be no worries.

hi thanks for the info. I really wants to understand who are the investors ??
I mean investor those who can effect the market.
Banks , Investment institutions .. etc. who are they. As I am amazed that the article tells about that the investor may
not be able to value the securities. But I thought they are very learned and sitting at the heart of the financial market
must be knowing all this stuff (assuming if we know it they must be knowing it better). I think this problem is deep rooted
and we only come to know when the damage has already been done. In fact we look for the answer try to convince ourselves that it is true.
Please forgive me incase I didn't get the article right.

As Alan Greenspan continued his 'cheap money' practices, the real estate bubble kept growing. The loans that were chopped off and sold to 'investors' (other than the originating bank) were part of a chain that hinged on the sucker at the bottom making his monthly installments on time. When this guy defaulted, everyone in the chain got affected. As the bubble burst (meaning the RE prices came down), the investors who expected to profit from appreciating prices lost value. This part is well known and well discussed.

Just as our govt. in India is reluctant to publish the true statistics in a major accident (where the death toll is expected to mount as days go by), the FED is reluctant to release the true figures of sub-prime effects. It has now been reported at $1 trillion from its humbler beginnings at $100 billion!! And it is still not showing any signs of slowing down. Add to this personal loan defaults as more americans lose jobs, and it only points to worse times to come yet! The Europe, Mideast and richer countries like Japan and China that have parked their sovereign funds in US treasury securities are only too willing to tow the US line. They follow economic policies that are in tandem with those of US's.

If global economic co-operation can subvert a major crisis, then a corollary follows that when a major crisis does befall (despite their best combined efforts - which really means that the people stop buying things) all the countries in the world will fall like nine pins. Obviously the 'weaker' countries will face this challenge before others. Our task as investors (not traders) is to maximise cash position, wait for the fall to completely play itself out, watch for STRONG global cues of revival, and then cautiously re-enter the market.

The depression of 1929 took about four years to recover (1933), but this time it may be a different story. One cannot get passionate about shares. I think the era of buying so-called 'good' company shares and then sitting on them until you have a reasonable profit may have changed. One still has to hunt for 'good' companies, but be willing to book profits when the time comes because any number of external pressures may tend to wipe out such companies. In other words, one has to constantly monitor one's portfolio. Even if you invest in a Mutual Fund, you still have to watch your NAV and its performance etc.

Tell that Chinese guy that we already live in interesting times...

Paresh