US sub prime mortgage crisis and Australian investors

info · Joined: 07 Feb 2005 Posts: 23

The US sub-prime mortgage crisis will get worse before it
gets better. Total losses could be high (e.g, US$100 billion)
but this is small relative to the US mortgage market overall.
I do not believe this is enough to trigger a US recession.
The direct impact on Australian investors is likely to be
minimal. However, the main risk is if the crisis leads to a
further slump in the US credit and share markets. It will
probably be a rough ride in the short-term.

Why it will likely get worse before it gets better

A big proportion of US sub-prime mortgages on low initial “teaser”
loans are due to reset to normal higher rates over the next 12
months. However, many borrowers will be unable to refi nance
back to lower rates as they have been doing because of tougher
lending conditions, made worse by tighter regulatory standards
and falling house prices. Tighter lending conditions, along with
the huge stock of unsold homes (3.8 million), will likely lead to
a further fall in house prices, all of which could result in further
delinquencies and defaults. This in turn will likely feed back into
further problems for sub-prime securities markets.

Implications for Australian investors
The key area of direct exposure of Australian investors to the
sub-prime crisis is via high yield funds, international fi xed interest
funds and more broadly, via hedge funds. While some Australian
yield-focussed hedge funds have run into trouble via their
exposure to sub-prime backed CDOs and the fl ow-on to CLOs, the
direct impact on most Australian investors is likely to be minimal:
Most high yield funds Australians invest in are far more
diversifi ed and far less reliant on gearing, and do not involve a
lot of fi nancial engineering as CDOs do;
Similarly, most global bond funds are well diversifi ed across
countries and the type of debt they hold;

Finally, most investors are exposed to hedge funds via funds of
hedge funds which are diversifi ed across a range of strategies and
a range of asset classes. Several hedge funds have actually been
running short positions in US sub-prime debt, so their return has
actually gone up as sub-prime debt has fallen in value.
Providing investors have well diversifi ed portfolios, the direct
exposure of most Australian investors to the US sub-prime crisis
is likely to be minimal. The main risk is contagion with sub-prime
problems affecting broader credit and equity markets. This is
happening to some degree and it may be a rough ride over the
next few months but is unlikely to last, particularly in equities, as
it is unlikely to lead to serious economic problems in the US.

Conclusion

The crisis in US sub-prime mortgages likely has further to run.
It may not threaten prospects for a relatively mild landing in
the US economy and a favourable outlook for equities, but
could contribute to a rough ride in the short-term. The recent
weakness in share markets may yet continue, but this is likely to
be just another correction in a still rising trend.