With the stock market going for a tizzy and the volatile times looming
large. Two things have been synonymous with the market crash,
a) Sub-prime effect
b) Yen carry trade….
It is always beneficial to know
what are the actual things affecting you rather than following market
rumors… so I came across this and thought I will share…
The Bombay Stock Exchange Sensitive Index or Sensex as it is more
popularly known fell by 643 points on Thursday, August 16. Various
stock market experts have blamed the sub-prime crisis in the United
States. So what is this sub-prime crisis? And why is it having such a
decisive impact on the Indian stock market? To know more read on.
Essentially it all starts with an American wanting a home loan. But
there is a slight problem. He doesn't have a great credit rating. So a
bank will not give him a home loan. Enter a second American who has a
good credit rating and is willing to take on some amount of risk.
Given his good credit rating the bank is willing to give him a loan.
The bank gives the second American a loan at a certain rate of
interest.
The second American divides this loan, into a lot of small tranches
and gives it out as home loans to lots of other Americans like the
first American, who do not have a great credit rating and to whom the
bank will not give a home loan.
He gives out a loan at a rate of interest at a higher rate of interest
than the rate he has borrowed from the bank. This higher rate is
referred to as the subprime rate and this home loan market is referred
to as the subprime home loan market. Also by giving out a home loan to
lots of individuals, he ensures, that even if a few of them default,
his overall position is not affected much.
The question that crops up here is, if this home loan market is
subprime, what is prime? The prime home loan market essentially refers
to individuals who have good credit ratings and to whom the banks lend
directly.
Now back to the subprime market. The individual giving out loans in
the subprime market does not stop here. He does not wait for the
principal and the interest on the subprime home loans to be repaid, so
that he can repay his loan to the bank, which has given him the loan.
What does he do? He goes ahead and securitises these loans.
Securitisation essentially involves, converting these home loans into
financial securities, which promise to pay a certain rate of interest.
These financial securities are then sold to big institutional
investors. And how are these investors repaid? The interest and the
principal that is repaid by the sub-prime borrowers through equated
monthly installments is passed onto these institutional investors.
The individual giving out the sub-prime loans, takes the money that he
gets from selling the financial securities and passes it on to the
bank, he had taken the loan from, thereby repaying the loan. And
everybody lives happily ever after. Well not really.
The sub-prime home loans were given out as floating rate home loans. A
floating rate home loan as the name suggests is not fixed. As interest
rates go up, the interest rate on floating rate home loans also go up.
As interest rates to be paid on floating rate home loans go up, the
EMI’s that need to be paid to service these loans go up as well.
The higher EMI’s hit the sub-prime borrowers hard. A lot of them, given
their poor credit rating, defaulted. Once, more and more sub-prime
borrowers started defaulting, payments to the institutional investors
who had bought the financial securities stopped, leading to huge
losses.
Well, that still does not explain, why stock markets in India, fell?
Institutional investors, who had invested in securitized paper from the
sub-prime home loan market, saw their investments turning into losses.
Most big investors have a certain fixed proportion of their total
investments invested in various parts of the world.
Once investments in the US turned bad, more money had to be invested
in the US, to maintain that fixed proportion. In order to invest more
money in the US, money had to come in from somewhere.
And this money came in from emerging markets like India, where their
investments have been doing well. So these big institutional
investors, to make good of their losses on the sub-prime market, have
been selling their investments in India and other emerging markets.
Since the amount of selling in the market, far overweighs the amount
of buying, the Sensex has been on a falling spree.
And that explains the title of this piece 'When Americans sneeze India
catches cold'.
And what the moral of the story is that despite the fundamentals of
certain stocks being good, they saw an unnecessary decline as they
were shorted indiscriminately as they were owned by these FII's who
needed money to stabilize their home playing field. So the stocks got
sold because these people owned them… Being an optimist, I think there
are good opportunities emerging and one should buy into stocks if they
convinced of the fundamentals and the valuations.
large. Two things have been synonymous with the market crash,
a) Sub-prime effect
b) Yen carry trade….
It is always beneficial to know
what are the actual things affecting you rather than following market
rumors… so I came across this and thought I will share…
The Bombay Stock Exchange Sensitive Index or Sensex as it is more
popularly known fell by 643 points on Thursday, August 16. Various
stock market experts have blamed the sub-prime crisis in the United
States. So what is this sub-prime crisis? And why is it having such a
decisive impact on the Indian stock market? To know more read on.
Essentially it all starts with an American wanting a home loan. But
there is a slight problem. He doesn't have a great credit rating. So a
bank will not give him a home loan. Enter a second American who has a
good credit rating and is willing to take on some amount of risk.
Given his good credit rating the bank is willing to give him a loan.
The bank gives the second American a loan at a certain rate of
interest.
The second American divides this loan, into a lot of small tranches
and gives it out as home loans to lots of other Americans like the
first American, who do not have a great credit rating and to whom the
bank will not give a home loan.
He gives out a loan at a rate of interest at a higher rate of interest
than the rate he has borrowed from the bank. This higher rate is
referred to as the subprime rate and this home loan market is referred
to as the subprime home loan market. Also by giving out a home loan to
lots of individuals, he ensures, that even if a few of them default,
his overall position is not affected much.
The question that crops up here is, if this home loan market is
subprime, what is prime? The prime home loan market essentially refers
to individuals who have good credit ratings and to whom the banks lend
directly.
Now back to the subprime market. The individual giving out loans in
the subprime market does not stop here. He does not wait for the
principal and the interest on the subprime home loans to be repaid, so
that he can repay his loan to the bank, which has given him the loan.
What does he do? He goes ahead and securitises these loans.
Securitisation essentially involves, converting these home loans into
financial securities, which promise to pay a certain rate of interest.
These financial securities are then sold to big institutional
investors. And how are these investors repaid? The interest and the
principal that is repaid by the sub-prime borrowers through equated
monthly installments is passed onto these institutional investors.
The individual giving out the sub-prime loans, takes the money that he
gets from selling the financial securities and passes it on to the
bank, he had taken the loan from, thereby repaying the loan. And
everybody lives happily ever after. Well not really.
The sub-prime home loans were given out as floating rate home loans. A
floating rate home loan as the name suggests is not fixed. As interest
rates go up, the interest rate on floating rate home loans also go up.
As interest rates to be paid on floating rate home loans go up, the
EMI’s that need to be paid to service these loans go up as well.
The higher EMI’s hit the sub-prime borrowers hard. A lot of them, given
their poor credit rating, defaulted. Once, more and more sub-prime
borrowers started defaulting, payments to the institutional investors
who had bought the financial securities stopped, leading to huge
losses.
Well, that still does not explain, why stock markets in India, fell?
Institutional investors, who had invested in securitized paper from the
sub-prime home loan market, saw their investments turning into losses.
Most big investors have a certain fixed proportion of their total
investments invested in various parts of the world.
Once investments in the US turned bad, more money had to be invested
in the US, to maintain that fixed proportion. In order to invest more
money in the US, money had to come in from somewhere.
And this money came in from emerging markets like India, where their
investments have been doing well. So these big institutional
investors, to make good of their losses on the sub-prime market, have
been selling their investments in India and other emerging markets.
Since the amount of selling in the market, far overweighs the amount
of buying, the Sensex has been on a falling spree.
And that explains the title of this piece 'When Americans sneeze India
catches cold'.
And what the moral of the story is that despite the fundamentals of
certain stocks being good, they saw an unnecessary decline as they
were shorted indiscriminately as they were owned by these FII's who
needed money to stabilize their home playing field. So the stocks got
sold because these people owned them… Being an optimist, I think there
are good opportunities emerging and one should buy into stocks if they
convinced of the fundamentals and the valuations.
