subprime market - jittery effect

With inputs from:
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/08/17/MNHSRK67M.DTL&tsp=1

A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are often turned away from traditional lenders due their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment.

The great mortgage crisis of the summer of 2007 has slopped over into nearly every nook and cranny of the financial markets, laying low stocks that until a month ago had been on a great bull run.

On Thursday, U.S. stocks took off on a wild ride, the Dow Jones industrial average falling as much as 343 points in midday trading before recovering and finishing at 12,845.78, down just 15.69 for the day. At the day's lowest price, major market averages were 10 percent below highs posted a few weeks ago, a fall that would qualify as a correction.

Despite Thursday's rebound, stocks remain vulnerable, analysts caution.

The reverberations from the collapse of the subprime mortgage market have yet to fully play out, they say. The global investment market is more tightly interlinked than ever before. Troubles in one corner, such as mortgages, have profound ripple effects on investments such as technology stocks, gold and oil, which seem far removed.

"This is classic financial contagion," said Russ Koesterich, a portfolio manager at Barclays Global Investors in San Francisco. "You've got people in multiple markets. Losses in one force them to capitulate in others."

So far, the main actors in the stock market sell-off have been institutional investors and big money managers, many of whom specialize in risky and complicated investments. Retail investors have mostly sat out the selling spree of the last few weeks, market watchers say.

The root of the problem lies in tectonic shifts in financial products in recent years.

Exotic financial products created from mortgages in the last decade or so are being tested for the first time in a market crisis, pushing investors into uncharted territory. No one knows the full extent of the losses caused by the failure of a mushrooming number of subprime mortgage borrowers to pay back their loans.

A mortgage made in, say, San Jose gets sliced and diced - some of the interest payments are packaged as securities and sold to an investment fund in New York, and part of the principal is put into a security sold to a bank in Germany. When the borrower stops paying the monthly mortgage, the investors lose income. What's more, they can't sell those exotic mortgage securities because no one knows what they're worth.

"People have been moving into new territory," said Zachary Karabell, a portfolio manager with Fred Alger Management in New York. "It's a complex system that nobody fully grasps."

The mortgage investors suddenly face a desperate need for cash - perhaps to pay back margin loans they took out to buy the securities in the first place or maybe to pay off big clients who are yanking their money as fast as they can.

What makes this crisis so hard to measure is that trillions of dollars worth of U.S. mortgage securities have been sold around the world, in many cases to hedge funds, those secretive, largely unregulated investment vehicles that don't have to disclose their finances.

In recent years, institutional investors largely stopped paying attention to the risks of buying mortgages made to people with bad credit records. Suddenly, they have become allergic not only to subprime mortgages but to almost any kind of risk. That means all borrowers - from a consumer who wants a home equity loan to a hedge fund that wants to finance new investments - must pay more for money.

That's a key connection to the stock market. Hedge funds and other big institutions that need cash can't borrow easily. Instead, they've been selling anything that isn't nailed down, whether it's crude oil or shares of hot technology companies.

The process feeds on itself. Because exposure to bad mortgages is so hard to calculate, a wide array of lenders, financial institutions and banks fall under suspicion. Rumors fly.

Rumors have their share in EMs (emerging markets) as well. The interlinking of markets has created a behemoth of a financial system, where ripples spread every where, including countries like India.

The volatility is measured from the option prices, and these reveal that over the years, volatility is actually declined. There is a reduction in the debt-equity ratio of companies, resulting in stronger equities. The fundamentals are strong, so we can be bullish in the long term. Short term jitters will keep happening..just ignore them, and use such falls to buy!