Disturbances that took place US Subprime Housing sector - Free Essay Example

The disturbances in the US subprime housing sector graduated into a full blown economic downturn by the end of the year 2007, remaining underestimated for most of the year 2008, aggravated by current account deficits in the United States and Kingdom. The crisis was financed by excess flow of savings from developing economies and oil exporting countries and led to lax monetary policies and banking regulations, as well as misperception of risk, and loose financial regulations. Investors became aware of the downturn only after the collapse of Lehman Brothers in September 2008. By then, liquidity had dried up. To counter the crisis, governments in developed and emerging economies responded by injecting credit into their financial sector, nationalizing banks, and cutting down interest rates. Despite critical implications, Asian countries remained well placed than others China and India being the pioneers. Nevertheless, 2010 has been a year filled with uncertainties for the world economy. Primarily affected have been exports and equity markets, currency and credit markets, among others. Causes Subprime Lending As a result of the dot-com bubble burst and the consequent recession in 2001, the Federal Reserve Board (Fed) took a decision to cut down short-term interest rates from 6.5% in 2000, to well below 2% in 2003, an incentive for investors across the globe to park their investments on financial instruments offering substantial returns. Subprime lending is referred to the availability of loans to people who may have difficulty in repaying the borrowed money. Bundling prime and subprime mortgages backed with assets (sellable property) making probable interest rates look attractive. Subprime lending led to a rise in home ownership in the US from 64% in 1994 to 69.2% in 2004. According to the National Home Price Index by SP/Case-Shiller, between 1997 and 2006, housing prices in the US rose by 124%. Homeowners started refinancing their properties and obtained second mortgages against the additional value of the property to use it for consumer spending beyond their means. Wall Street firms purchased mortgages, bundled and sold them off to investors as Mortgage-Backed Securities (MBS) which offered much higher returns than safer assets. With real estate prices soaring, foreign capital flowed from countries with current account surplus, namely, the fast growing Asian economies and the oil exporting nations. However, during 2006 and 2007, interest rates began to rise while housing prices started to drop, making refinancing difficult. As a result, defaults and foreclosures increased drastically when the easy initial terms expired and housing prices failed to rise as anticipated. Consequently, the US household debt as a percentage of income touched 130% in 2007, a 30% jump from the earlier rates. As corrective measures, between 2004 and 2006, the interest rate was raised from the existing 1% to 5.25%., however, the housing prices did not rise as anticipated. On the contrary, it started falling rapidly around 2006-2007. The institutions that invested in MBS encountered heavy losses. The result was housing and credit market bubble. Lessons Learned Financial institutions and investors should research and base financial strength apart from a high credit rating, while regulators should stop dependence upon the monopoly of a few credit agencies. Instead of excessive risks, institutional investors should focus on portfolio diversification for the long term, since short speculative runs would only prove futile. Portfolio investment should spread across all important sectors, and reach across to developed and emerging international markets. The collapse of Lehman Brothers alongside that of the US mortgage securities market causing the erosion of consumer trust and loss of liquidity is a proof of how making all investments into the same company, industry, sector or country could be catastrophic for a financial institution. Opportunities In spite of regional integration in terms of trade investment, Asia-Pacific has limited capital flow due to a lack of information, differing rules and regulations, undeveloped financial infrastructure and a lack of relevant financial instruments. According to Asia-Pacific market report for October 2009 by Credit Lyonnais Securities Asia (CLSA), Asia is at the foothold of demographically driven growth for domestic investment. The Alpha Advisory report in 2009 states emerging markets accounted for over 85% of the global population, 75% of landmass, 70% of foreign reserves, 50% of global GDPÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ and a mere 10% of the global equity market capitalization. Survey data from the years 2009 and 2010 on Asia reveal greater preference for equities. The private equity investment levels in Asia, in the year 2009 were the same as in the years 2005-2006 because the Asian market remains underexposed to private equity investments. By 2020, China has been projected to be the largest economy of the world, while India is expected to become larger than Japan, taking the third place after China and the US. Therefore, China and India hold greater investment opportunities for Asian investors, followed by Korea and Taiwan. Policy changes broadening information exchange, harmonizing institutional settings, improving financial infrastructure and information and developing products would further increase cross border portfolio flows. China China, the leading Foreign Direct Investment (FDI) recipient of the world remains an attractive destination for foreign investments. The Qualified Foreign Institutional Investors (QFII) in 2007 allows investors qualified by the State Administration of Foreign Exchange to invest in the Chinese stock market. In the first half of 2009, China accounted for one-third (US$7.3 BN) of the total amount of PE investment in Asia. In terms of the total number of equity investments made in 2009, the largest share went to the manufacturing industry (19%) followed by IT, Internet, energy, and healthcare. However, in terms of the total value of investment made, the financial sector received US$18.4 BN, followed by energy, manufacturing, and food and beverages, all of which are valuable long term opportunities for institutional investors. Additionally, the Chinese distressed debt market for the Asian investors in the form diversifying their portfolio, and receiving attractive returns at the same time. For example, Shoreline China Value I, L.P. a China-focused distressed asset investment firm managed by Shoreline Capital, witnessed oversubscription in 2008. India In India, institutional investor interests focus on key sectors like pharmaceuticals and healthcare, banking and finance, mining, Fast Moving Consumer Goods (FMCG), and Information Technology (IT)/Information Technology Enabled Services (ITeS). On the other hand, PE firms struck deals in cement, infrastructure, education, and real estate sectors, among others. According to India PE Report 2010 from Bain Company, a global consultancy, PE and venture capital (VC) investments are projected to reach US$17 BN by the year 2010. Other Asian Countries Other Asian countries like Indonesia, the Philippines, and Japan have also recorded increased flow of FII between 140-220% in 2010. On the other hand, South Korea and Taiwan have recorded lower inflows than other countries ranging between 28 50%. Commodities Asian financial investors, similar to those worldwide, are worried about the higher rates of inflation and are therefore keen on mitigating the risk through increased aggressive investment in commodities. State-owned companies in China like Chinalco, and Minmetals, in collaboration with state banks such as the China Development Bank, have invested in numerous natural resources deals in Africa, Australia, and Russia. Simultaneously, the Chinese government is using its foreign reserves to build crude oil reserves and building stocks of precious metals like gold, copper, and iron ore. Recommendations Regulations The financial instruments which make the market more efficient also introduced embedded or hidden leverage into balance sheets which complicate counterparties and transmit, rather than mitigate risk. To ensure mortgage underwriting and regulatory standards remain high, sponsors should continue their economic stakes with exposure to loss to ensure their vigilance and alignment with all parties. Transparency To safeguard future economic crises, institutional investors need to operate under a carefully regulated, transparent and capitalized environment. Rates of transparency, varying widely, from relatively higher levels in Hong Kong, to a more restrictive and opaque market in China, pose the biggest challenge to the institutional investors, and should be carefully assessed for risk. Diversify Outside The Dollar A single solution to both these objectives would be the movement towards a single Asian currency. It would be a safe investment alternative for Asian investors to enhance trade, and rule out exchange rate uncertainties, boost investment and monetary bonding within the region and grant more clout in the international market, and also limit the impact of cross-country effects. Otherwise, the Chinese Yuan or Renminbi is an alternative investment. The Asian Development Bank priced their first international bond denominated in Renminbi on October 19, 2010, which carries a ten-year bullet maturity with a critical long-term pricing reference for other borrowers. Gold Gold should always be included in an optimally diversified portfolio. Gold would never lose its intrinsic value, serving as a hedge against inflation. Investments in gold in 2009 surpassed the corresponding demand of the entire year of 2008. Large institutional investors, such as hedge and pension funds are allocating investment on gold and gold shares. Construction Construction and healthcare sector provide new avenues of long term investment for institutional investors. The construction sector provides critical infrastructure and requires occupation of unskilled work force, cheap labour without training requirements. This would forth employment and revenue for the economy, a multiplier effect on the economy and ultimately responsible for the Gross Domestic Product (GDP). Although healthcare investment has been in demand worldwide, investment in the healthcare sector necessitates a multifaceted approach in understanding the underlying trends that institutional investors should follow before making investments. The aging population and baby boomers; longer lifespan with chronic diseases; obesity and diabetes epidemics; the global reach of diseases, among others, are positive trends that drive investment in the healthcare sector. Healthcare investments in the form of sponsorships of the education of specialists; financing the development of a chain of hospitals or polyclinics, technological equipment and patented drugs promises rich rewards and good dividends for investors. Conclusion Could the crisis have been averted? Finance ministers of the ASEAN members as well as China, Japan, and South Korea have agreed to set up a crisis fund worth US$120 BN to help the region handle credit crunch and overcome the global financial crisis. With all this preparation to ward off another crisis, it is still a little known fact that the magnitude of the crisis was due to bond salesmen peddling American CDOs overseas. In the world of subprime lending, it was all about transferring risk. The last one holding the bond was a fool.