It's not all about China
While markets were generally firmer for most of February, a sharp drop in the Shanghai stock market on 27 February triggered a bout of worldwide risk aversion.
It is noteworthy, however, that the Chinese Index remains 4% higher year to date, while the MSCI and S&P are slightly down. While there is a clear connection between perceived Chinese demand for raw materials and world economic growth, there is more going on here. This is not all about China.
Risk appetite has been in a bull market for almost four years. A healthy appetite for risk results in stronger equity markets, tighter credit spreads, outperformance of small-cap stocks and higher valuations for emerging markets securities. The search for excess return generally drives down risk premia in risky asset classes. At some point in the cycle, complacency sets in; too many players are positioned the same way and risky assets correct. Over the past few days spreads in US junk bonds widened as much as 40 basis points. Small-cap stocks underperformed large-caps by about 2%. The yen rose 4% against the dollar as some participants took risk off the table in this version of the carry trade.
In one example of a risky asset, which had been bid up to unsustainable levels by indiscriminate yield chasers, subprime mortgage pools in the US have been hit hard in the past two weeks. Subprime mortgages are loans granted to home buyers with a poor credit rating or no credit history - possibly without documentation of income, often at loan-to-value ratios close to 100% of property value, and frequently with a low initial interest rate. Over the past couple of years, mortgage lenders eager to make loans offered 2-28 mortgages in which the borrower is offered a low teaser rate for the first two years. After the two year period, the rate can jump several percent. If the borrower has insufficient income to support the new monthly payment, he can attempt to refinance by switching to another bank offering a different teaser, he can sell the property or he can default. In the previous environment of rising house prices, owners were likely to be able to sell or refinance. As house prices have now started to fall in some parts of the country, these options are disappearing for the more stretched borrowers. Also, easy refinancing terms are drying up as banks are now beginning to tighten up their lending practices. A large number of 2-28 loans will reach the end of the initial two-year period in 2007; the serial refinancers will be forced out of the game.
Over the past few weeks, subprime loan delinquency rates (defined as loan payments more than thirty days past due) have risen to 13%, versus just 5% in January. This compares with a peak delinquency rate of 15% reached during the 2001 recession. However, it is likely that the problem will be more severe in this cycle as more owners have committed a greater portion of their disposable income to support mortgage interest. Subprime mortgages in the US economy total about $1.3 trillion and as much as 35% of this total is estimated to be in stated income loans in which the borrower has not been required to document his income. Due in part to such lax lending practices, lenders will ultimately be forced to foreclose on perhaps 20% of the subprime total.
The increased volatility in financial markets is due to the fear of spillover effects. The risks are that:
1.more homes will be put on the US market where there is already a seven month supply of inventory;
2.this could further depress home prices and produce a negative wealth effect;
3.consumer spending will slow and this will lead to earnings disappointments; and
4.some Wall Street banks will take a loss on their exposure to failed subprime lenders.
In previous bouts of risk aversion over the past couple of years, the focus of attention was on General Motors credit or on the breakdown of correlation between CDO securities. On each occasion price falls in risky assets were met by buyers at lower levels. This time, the proximate cause is the subprime mortgage market. To the extent that the world is still awash with petrodollars looking for a home, the result could be the same this time. On balance, however, given the prior levels of complacency and occasional recklessness with which some assets had been priced, it is likely that this episode of risk aversion is not yet over. In times like these, the discipline to avoid the latest fad and to invest in managers with a focus on value should pay dividends.
