How’s your risk appetite today?

For many years, the US saw a boom in the housing market. Individuals with the ability to pay high EMIs availed of ‘prime’ loans. In addition, there arose a ‘sub-prime market’, where home loans were given to people with a poor ability to repay. Financial companies pushed loans in which the customer had very low repayments in the short term but after that the EMI would rise sharply.

• Did loans to people with a poor ability to repay make good business sense?

The higher risk of default meant that the interest rates charged on these loans were higher. And, financial engineering where the loan basket was ‘securitised’ — cut up into less risky and more risky assets and sold to lenders with different risk appetites — allowed lenders to make profits.

• Why did this business model run into trouble?

From 2004 to 2006, US interest rates rose sharply, leading to an upsurge of defaults on home loans. When a home loan defaults, the bank repossesses the house and sells it on the market. But if the value of the house falls during this time, as has been happening in the US, the lender is unable to recover his loan. These financial companies and those who fund them may go bankrupt.

• What is happening in the ‘sub-prime’ market now?

Most facts about the sub-prime market were becoming known in 2006. The consensus view at the time was that while the outlook for housing was bad, and while sub-prime loans would do badly, these difficulties would not shake the overall financial market.

This perception has changed in recent weeks as markets have seen dropping home prices and continued worsening of defaults among sub-prime loans. High-profile failures of financial firms working in the sub-prime mortgage market has shaken the people’s confidence. People are willing to take less risk for the same returns today. They are ‘re-pricing’ risk.

• What are the other signs of a ‘re-pricing’ of risk?

In recent weeks, there has been a significant change in risk perception in the US bond market. When a bond is issued by anyone other than the government, it commands a ‘credit risk premium’ — it has to pay a higher interest because of the risk of default. Credit risk premia on the US corporate bond market have risen sharply. Heightened risk perception is also seen in US stock prices. This has led to a ‘re-pricing’ of risk on all financial assets.

• What could be the impact of the volatility in US stock markets on Indian stock markets?

There is a close, but not perfect, relationship between the risk premium required for corporate bonds in the US and the risk premium required for purchasing emerging market stocks. Both reflect a common underlying appetite for risk amongst global investors. Events in the US have perturbed global investors and they are now demanding a higher premium in return for bearing any kind of risk, including that of stocks of emerging market economies, including India. When the emerging markets risk premium goes up, prices of emerging markets assets go down. We are seeing lower prices in India for shares, corporate bonds, and real estate.

• How might this story shape up in days to come?

A good scenario envisages the equilibrating responses of markets. A gloomy scenario involves a loss of confidence of global investors in the engine of global economic growth. The ability of the US Fed to cut interest rates is limited by inflation in the US which has remained above the Fed’s target of roughly 2 per cent. Many assets worldwide — ranging from US housing to Chinese shares — are priced at very high valuations, and have a lot of headroom for continued price declines. It could be choppy times ahead.