Monday, August 13, 2007

Sub-Prime Worries and Sensex

Today two Goldman Sachs funds underperformed due to the global liquidity crunch. For those wondering what this huge fuss is about which is also affecting our beloved Sensex and shattering the Indian investor’s belief that we are insulated from global trends here is a brief explanation.

Over the past few years since the Dotcom bust, interest rates have been low. This means that globally loans have been easy to obtain, and the return on bonds have been low. In search of higher returns to meet their operating expenses, funds have invested in traditionally higher risk investments. These investments were rated as being secure because of the low interest rates. At low interest rates, it was assumed that the borrower could repay the loan.

Due to the low interest rates, banks and mortgage firms lent money to those who had shaky credit records. This debt was then passed onto funds who took them on as collateralised debt obligations (CSOs). Essentially the banks and mortgage firms passed on the risk of default to funds. When the borrowers defaulted, which is expected because they have a bad credit record, there were no buyers for this debt on the market. Due to a lack of buyers, the funds were faced with a liquidity crises, and therefore went bust. This was further augmented by the lack of faith from banks and other financial institutions in lending money to each other. Over the past week the LIBOR rate rose sharply. Leading to a lack of liquidity and central banks having to pump money into the system.

Since the funds in the US went bust, and they had liquidity issues, they liquidated their assets in other markets like Asia. This has lead to the fall of the Sensex over the past week. Over the last one week FIIs have withdrawn close to Rs 6000 crs from the Indian markets. Now central banks are trying to pump in money into the global system to assuage the liquidity crises, hopefully it will be successful, otherwise it might lead to a global recession.

Retail Investors worried by the volatile Sensex should stay put. The movements in the value of their portfolio does not matter, what matters is the value of the portfolio when it needs to be liquidated. If there are no pressing liquidity pressures, then investors should stay put because in the long term, the market will move only northward.

Further Reading: Financial Times, Business Week Economist TOI and Econbrowser (a more academic and technical piece)


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