The US housing bust and Dalal Street tumble

So what went wrong?

• Since 2003, there was boom in the US housing market. Subprime market rose fast, few checks and balances.

• From 2004 to 2006, US interest rates rose sharply. Subprime borrowers found EMIs rising, bringing in more defaults.

• Homes repossessed but by then boom reversed, home values down, lenders unable to recover their money

What’s the link to markets?

• Since 2000, a key change in US mortage market: lenders sold most of their loans, including risky subprime loans, to investment banks which converted these into “mortgage-backed securities” for large investors.

• Investment banks then inserted these risky securities into new investment instruments, called Collateralised Debt Obligation (CDO)

• Many of these got AAA rating as they were structured to offer higher yields than similarly rated corporate bonds. So risky securities got packaged as safe investments.

• These CDOs were then sold to large Wall Street players, including hedge funds, which are having to close down as they are unable to pay back investors wanting their money back.

Why shockwaves hit all markets?

• Trillions of dollars were pumped into the world’s financial arteries when interest rates were low four to six years ago. This increased liquidity pushed stock prices high. Now, as interest rates are hardening, these leveraged exposures to falling asset prices are in danger of loss. When creditors ask for their money back, it is the same trillions of dollars that will have to return, leaving fallen markets behind.

• Lenders are also “re-pricing their risk” which means it’s costlier for them now to sell these risky loan to larger companies

What’s effect on Sensex?

• If not hedge funds, FIIs may be forced to withdraw cutting losses. But this withdrawal is not going to mean the end of Indian equities.

• Aug 15 is an important date for markets. To withdraw money from hedge funds, 45-day notice period is required. So for the July quarter, July 1 to Aug 15 is application period. Post-Aug 15 could see redemptions in hedge funds. That may lead to ‘cascading liquidity withdrawal’ across emerging markets, including India, says Seshadri Bharathan, Director (Stock Broking) Dawnay Day AV Securities