Dear Mr Tan
Why are the subprime mortgages in America causing problems to the global stockmarkets? Surely, the economy in Asia is growing strongly. Why should it be affected by the mortgages in America?
REPLY:
The subprime mortgages were issued in America. A batch of mortgages are put into a portfolio, called an "asset backed security". This portfolio is divided into different tranches. The most secure tranches were rated AAA. The BBB tranche is high risk. The least secure are the equity tranche.
The investment bankers take the BBB tranches of many portfolios and put them into a new portfolio, called a CDO (collateralised debt obligation). The CDO is again issued into several tranches, from AAA to equity tranche.
The AAA tranche of the CDO actually comprise of many BBB tranches of the ABS (which are high risk). These CDOs are sold to funds in Europe and Asia.
When the American property market falls in value, many of the subprime morgages defaulted. This affects the BBB traches of the ABS and nearly all of the tranches of the CDOs. The AAA and AA tranches of the CDOs have falled in value, by a lot.
Many banks invested in these CDOs. When they fall in value, the banks have to book the losses. This caused their stock prices to fall. This is affecting the stockmarkets around the world.
Some of the money raised by the structured products sold in Singapore were also invested in the CDOs. They have also fallen in value.
There is nothing much that the investor can do about these structured products. If they withdraw now, they will suffer large losses. They can only wait for the maturity date, and hope that the market would have recovered.
If you read some of the structured products, they said that the investor may lose part or all of the principal. It can happen. Let's hope that it does not.
Thanks for your clear-cut explanation of CDOs. Could you share with us how is it the BBB tranches of ABS can be upgraded to AAA in the CDO?
ReplyDeleteWishing you well in your new endeavours!
Here's a very long story with the details:
ReplyDeleteInvestment Landfill: How professionals dump their toxic waste on you (Paul Tustain, BullionVault, 2 July 2007)
Lesson: Do not invest in products so hyped and complicated that you or your trusted adviser don't understand.
ReplyDeleteHere's a quote from Small Investors Seen as Safer in Stock Slide (New York Times, 13 Aug 2007):
"The excesses in the financial markets are now generally believed to reside in complex mortgage securities and other esoteric investments, not in the traditional stock and bond markets where average Americans put their money.
...
In the near term, average Americans can expect more turmoil and uncertainty in the stock market and may have a harder time obtaining mortgages. But investment experts say that ordinary long-term investors, as long as they are diversified, should worry less."