Subprime and Stocks — What Happened?
Kurt Brouwer August 20th, 2007
Financial markets around the globe have been weak and jittery in recent weeks. The following discussion is meant to give you some background on the subprime lending mess and how it spread throughout the financial markets.
Subprime Loans: Over the past few months, there has been an awakening by lenders to problems in home loans made to borrowers with low credit ratings. These are called subprime loans. In addition to creditworthiness issues, many of these borrowers bought homes with little or no money down and with adjustable rate mortgages that are now getting pegged to considerably higher rates.
The first and obvious result of these problems is that home prices are falling in the very regions that were hottest up until now, such as the East and West Coasts plus Nevada, Arizona and Florida. With falling home prices and higher payments, some homeowners have defaulted on their loans. That would normally be a manageable and relatively predictable outcome except for one other issue, which we will call securitization. Many of these subprime loans were bundled together with thousands of similar loans and sold in batches to investors-primarily institutions-all over the world. As these loans face rising rates of defaults, the value of the underlying security (that is the entire bundles of loans) is called into question. Hence, lenders are no longer willing to loan against these instruments.
As a result of this credit crunch, many institutions and companies-both near and far-are experiencing problems. Mortgage lenders are stuck with loans they cannot fund. Banks around the world are holding security collaterals that are of questionable value. Companies that routinely seek financing through commercial paper (very short-term borrowings) are facing higher interest rates or even an absolute refusal of their commercial paper until all this mess gets sorted out.
Subprime and Stocks: You may be asking yourself, “But what does this have to do with the stock market?” Good question. The answer is a lot. The first result was that stocks in home builders and mortgage lenders tanked. Also, a number of hedge funds (some independent and some tied to large brokerage firms such as Bear Stearns and Goldman Sachs) that had heavy investments in subprime loans sustained heavy losses. Next, many other financial stocks such as banks, brokers and insurance companies got driven down as investors began to wonder about their exposure to these types of loans. Because lenders were suddenly squeamish about collateral based on subprime loans, the prices of these securities fell. Hedge funds and other firms holding these suddenly-illiquid securities were forced to sell other positions, often high quality stocks. Once this began, the selling spread.
As a result of this entire cascade of problems, stocks have fallen from their recent highs both here at home and in overseas markets. The actual decline has been modest by historical standards, but the process has been scary to many investors because the markets have been so volatile from day to day. In historical terms, a stock market correction or decline ranging from 10-20% is not at all unusual. Corrections come along every few years and they are positive because they weed out the speculative excesses that inevitably creep in during protracted up markets.
Now, the central banks (including the Federal Reserve) have stepped in to provide a little calmness to the banks and other financial institutions. The Fed has cut one interest rate (the bank discount rate) and may cut the more important Federal Funds rate.
On a positive note, due to the problems in lower quality instruments, high quality bonds have done quite well. In fact, prices of Treasuries and other very high quality bonds have gone up.
Stock Valuations Good: Despite all the issues we have discussed, we believe the stock market is priced at attractive levels with, for example, an average price/earnings ratio for the S&P 500 of 16 or so. Corporate earnings have generally been good and we think stocks represent good value at these levels. We also think it is very possible that the stock market will be more volatile for a while as the financial markets deal with the issues we outlined above. And, we all know that unforeseen events such as terrorist attacks, oil price spikes and other factors can jolt the markets at any time. Nonetheless, our overall outlook is positive.
Economy Solid: We also believe the economy is solid. Clearly, certain sectors such as housing are weak. In fact, new housing starts just hit a 10-year low point as home builders have cut way back on building new homes. Other than housing and finance, most sectors of the economy are doing well. Unemployment is very low by historical standards, inflation is contained and interest rates are very attractive.
U.S. manufacturers are doing very well. Due to the lower exchange rate for the dollar, exports are booming. The dollar has fallen against some currencies, but that decline was from a historically high point. Exchange rates are currently in a normal historical range.
Two Final Throughts: We have been through many ups and downs in the economy and markets over the past 25 years. Despite the different circumstances for each crisis, we believe two things remain constant:
- The financial markets always have and always will fluctuate. And really, we mean all markets, whether in stocks, bonds, real estate, gold, collectibles–you name it.
- The financial markets recover and move on. At times, the rough patch can extend quite a long time, but ultimately the global economy is growing and carefully-selected investments will do well despite temporary setbacks.
However, during these volatile conditions, we believe it is necessary to maintain a systematic and disciplined investment strategy designed to minimize damage during the downturn, but also to profit when the markets turn up again.
–Rita Lee and Steve Janachowski contributed to this post.
- Investing , Mutual Funds , Personal Finance
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