Investors around the world, including South Africa, have noted with concern that many of their equity investments are now worth several percentages less, largely because United States homeowners with subprime mortgage loans have started defaulting on their loan repayments.
But although those in the know are bracing themselves for further shock waves from the US subprime lending market, local investors should think twice before abandoning their equity investment portfolios.
Gareth Bern, credit analyst at Prudential Portfolio Managers (South Africa), says it is very likely that the current defaults in the US subprime lending market represent only the start of what may become far greater defaults.
But he also reminds investors that the US subprime market represents only about 10% of the US mortgage loan market.
He bases his prediction on the fact that subprime loans are often granted at a “teaser” interest rate, which is adjusted upwards after, say, two years (depending on the loan).
A subprime housing loan is often the last financing resort for borrowers in the US, and is granted with little or no credit or income checks. They are often granted for a term of 28 years, at a reduced interest rate for the first two years.
“Considering that many of the subprime lenders have been going into arrears within the first few months of lending, the chances of these lenders defaulting when the teaser interest rate get adjusted upwards is extremely high.”
Quoting FitchRatings statistics, Bern says subprime loans issued in 2005 have been facing an interest rate increase of 3% from about 7% to more than 10%, causing greater numbers of these loans to go into arrears. The problem is, he says, that loans granted in 2006 at about 8% will face a rate increase next year when the teaser rate expires taking them potentially above 11%. The deduction is that the subprime default saga has only just begun.
“Since these are high-risk lenders anyway, the chances of them defaulting on these rate increases are extremely high,” says Bern.
He points out, however, that the biggest problem is not simply that the lenders are defaulting, but that the underlying property prices secured against the loans are unlikely to cover the loan value. This means, he says, that investors with exposure to these loans will suffer losses, the size of which will be determined by what value the underlying properties can be sold for.
Ripple effects
When significant numbers of subprime borrowers started going into arrears earlier this year, US banks and investors became more cautious and reduced their lending to the subprime market. This caused US subprime mortgage originators to lose their ability to make loans and without being able to make loans they couldn’t stay in business.
Bern says that as a result the second-biggest subprime originator in the US, New Century Financial Corporation (NCFC), was suspended on the New York Stock Exchange in March this year after it lost 90% of its value in the first two weeks of March. According to online search-trend statistics from Google Trends, the suspension of NCFC caused the term “subprime” to hit the world’s radar screens for the first time.
But what baffles many investors is why global markets took such a knock. Bern explains that the subprime lending saga caused what asset managers refer to as a risk event — a market correction caused by a specific event rather than a change in economic fundamentals.
Investors got spooked in this instance mainly because it is difficult to immediately see the wider knock-on effect that the subprime loan defaults could have.
It emerged quickly that hedge funds were affected because of their exposure to the more risky tranches of subprime residential mortgage-backed securities — securitised home loans sold to investors like hedge funds in different tranches carrying different risk ratings. And next in line were the banks that were lending money to hedge funds invested in securitised subprime loans.
No need to panic
Gerhard Cruywagen, chief investment officer at Prudential, points out that investors should remember that South Africa’s fundamentals have not changed and that local equities are currently attractively priced, especially given the latest fall in the South African equity market.
“In South Africa the outlook for earnings and interest rates has so far not been impacted in a meaningful way,” says Cruywagen.
He says it is also important for South African investors to understand that local banks do not offer subprime mortgage loans and that very few local financial institutions have any exposure to low-grade US residential mortgage-backed securities.