On February 27th the Chinese stock market plunged 9% on fears of increased government intervention in the booming Chinese economy. Combined with some disappointing news about durable goods spending, the broad market averages declined sharply, erasing many of our gains for the year. Two weeks later, the markets are still jittery, with the Dow swaying near that psychologically important 12,000 level. The latest concerns are regarding sub-prime lending–an important concept which I’d like to explain.
Back in 2001, 2002, and 2003, the economy was trying to recover from September 11th attacks and the bursting of the tech bubble. One way to jolt an economy when the overall sentiment is bad is to lower interest rates to the point where people will spend money just because it’s so cheap to borrow. During this time period, where money was exiting stocks and entering real estate, people were treating the housing market like it was a giant secret. Besides the low cost of borrowing, speculation was further driven by mortgage products offering no money down and adjustable rates. Many of the people buying these homes had a less than perfect (i.e. sub-prime) borrowing profile.
The danger with these products (which often isn’t properly disclosed or understood) arises 3, 5, perhaps 7-years later when these “adjustable rates” reset at a much higher rate. A payment of $1,500/month could jump to $2,500/month if you locked in during 2002, when rates were especially low. The result is that more people are defaulting on their loan payments and trying to unload homes which they don’t have any real equity in. This is a dangerous scenario for the housing market as people tend to rush for the exit at the same time.
Why does this affect the stock market?
In the innovative world we live in, mortgages get packaged up and sold to investors. The “securitization” of mortgages is a fairly new concept but helps create liquidity for lenders. It also offers a diversification tool for investment portfolios. In essence, you could be receiving your own interest payments if you own securitized mortgages within your portfolio. What’s crucial to remember is that many of these sub-prime lenders are companies which trade on the stock exchanges. These companies, along with larger financial firms which are involved in some aspect of the “packaging” process, rely on consumers making those monthly payments. If they don’t, or the payment consistency gets steadily worse, it ultimately affects a larger pool of corporate earnings. It’s sort of like a domino effect. As the default rates increase, it’s bad for everybody involved. At the broadest level, more homes could get listed for sale, resulting in lower prices for sellers and potentially better prices for buyers.
How you should handle these risks as an investor?
Just remember why you decide to keep money in the housing and stock markets. It’s as an investment. If you can’t handle market swings or think about the value of your house every day, it may not be the best investment for you. Price volatility and daily fluctuation is part of the game. The truth is, it probably shouldn’t be spoken about so much, but that’s the nature of the media. They keep you glued to the paper or screen to the point where you actually worry about things which you shouldn’t. I’m sure this brings in great advertising revenue for the television networks, but it’s not ultimately worth your time. Focus on how you earn money, and try not to get sucked into well-publicized stories. Most importantly, once you create a smart financial plan, stick to it!
As always, I’m here for questions and comments.
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