Sub-Prime Effect and Emerging Markets

What is Sub-prime?

Some borrowers may have issues like poor credit history or hard to prove income, which makesThem ineligible to borrow money at prevailing market rates or prime rates. Sub Prime Lending is thePractice of financing such borrowers at a higher than prime rate. Such loans are considered riskyBecause of high interest rates, bad credit history and lack of resources to pay off the loans. Sub primeMortgage lending refers to such loans extended in the housing market.Sub-prime mortgage issues began to crop up when the housing prices in the US began to softenAnd the borrowers started to default on loan repayments. Loan defaults led to rising rate of sub primeMortgage foreclosures, which further led to a few sub prime mortgage lenders to fileBankruptcy. As a result, participants in the market with exposure to sub-prime mortgage backedSecurities began to witness mark-to-market losses. They also faced liquidity crunch, as no buyersWere willing to buy such paper.

The Contagion Effect

Market participants who had exposure to sub-prime mortgage securities as well as risky assets,covered up for sub prime mortgage losses by reprising the risky assets. Due to this, other leveragedequity market participants found it difficult to service their cost of leverage. This led them to deleveragetheir exposure in the form of further re-pricing of risky assets in US. Due to integration ofglobal financial markets, risky assets in other emerging markets also got re-priced as a spill overeffect. Several central bankers pumped funds into the economy to ease the liquidity tighteningcaused by sub-prime mortgage issue.

Impact on emerging markets

The impact of the sub-prime effect on emerging markets is hard to gauge. There are two parts to it. One is the impact on the real economies and another is the impact on the stock markets. Due toMacro policies, structural policies and domestic consumption, the fundamentals of emergingEconomies including India continue to remain strong. This might act as a cushion against any majorFinancial setback in the US. However it’s early to gauge whether the sub-prime issue has thePotential to disrupt the US imports and to that extent affect economic growth of emerging markets.As far as the stock markets are concerned, they may take some hit because of de-leveraging doneBy market participants. Time and again these kinds of events affect market sentiment leading toBouts of corrections. We believe that such corrective dips present an opportunity for investors to Invest in emerging markets at relatively attractive valuations.