US Subprime Problems
Subprime mortgages can best be summarised as loans made to borrowers with relatively poor credit ratings. The popularity of subprime loans grew on the back of sustained increases in US house prices between 2000 and 2005, coupled with historically low interest rates. However, in late 2006, the US subprime industry began to unravel as overextended borrowers struggled to repay loans as a result of rising interest rates and falling house prices. The result was a steep rise in foreclosures, which
sent shockwaves reverberating throughout the US economy and stock markets and is the main reason behind the global credit crunch seen today.
Impact on UK Investors
So if the credit crunch was brought about by lax US lending practices, why is it affecting UK investors? Well, in the US subprime loans are often amalgamated together into mortgage-backed securities (MBS), which are then sold to financial institutions across the world, including many of the FTSE 100 companies that are likely to feature heavily in your portfolios. Barclays, for example, was rumoured to have a £10bn exposure to subprime securities, which caused a 10% fall in the share price in just few hours last month. The bank's shares rebounded when it revealed later in the month that its true exposure was much less, but the stock is still down over 23% year to date.
Local lenders such as Northern Rock, where the subprime panic led to the first run on a UK bank for over a century, have also been affected. The irony there was that Northern Rock was solvent; they were simply the first major UK victim of the credit crunch. The bank had little UK and virtually no US subprime exposure, but they were unable to raise funds in the wholesale money markets as banks began to horde liquidity in order to protect their own solvency from being called into question. The upshot is a 90% fall in value of Northern Rock’s shares for the year to date and a nasty headache for the company's shareholders.
Property funds have been among the worst hit segment of the market. This owes to a combination of factors, but one of these is the credit crunch that has affected deal flow in the commercial property sector. Needless to say, investment funds with heavy concentrations in banks and other financials have also been hurt. Among them are specialist financial funds such as Jupiter Financial Opportunities and New Star Global Financials, as well as more diversified funds. Carl Stick's Rathbone Special Situations, for example, held a reasonable amount of Northern Rock before the problems highlighted above put pay to any hopes of profits on the stock.
Concerns over Barclays' subprime exposure have also harmed the performance of many income funds, such as New Star Higher Income and JPM UK Equity Income, who hold the stock for its impressive yield. As you may imagine index trackers have also been caught up in the problems. For example, funds tracking the FTSE 100 are forced to hold over 7% of HSBC, which has not escaped trouble; the stock is down 11% YTD.
What's Next for the UK Market?
Unfortunately, we do not believe that the worst is behind us. In fact, for the UK it could just be the beginning. Rapid house price inflation and historically low interest rates have led to an increase in consumer debt in the UK. As a result we have seen an increase in self certification and subprime mortgages – sound familiar? The UK housing market is now showing similar indicators to those seen in the US a couple of years ago. Now house price growth is beginning to stagnate and many who relied on the growth in value of their homes to finance their lifestyles could be in trouble. If property prices begin to fall, overextended borrowers could be exposed, which in turn would have a further knock on effect on banks and mortgage lenders. This would be especially true for those banks involved in subprime lending, as unlike in the US, UK subprime loans are not securitised and sold on – they are simply held on the banks balance sheets, and it would be them and them alone who would take the hit.
As a result, banks are becoming more vigilant in their lending practices, and the FSA has identified the subprime problem as a major supervision area for the future, as the latest figures show UK subprime loans to be around 8% of the overall market – around £16bn. But is this a case of closing the stable door after the horse has bolted? Already we are seeing a rise in foreclosures on UK properties as variable-rate borrowers struggle with repayments after a series of interest rate rises. Many fixed-rate borrowers also now need to refinance their mortgages at much higher rates after their initial tie-in periods come to an end – further exacerbating the problem and substantially reducing the deposable income of many borrowers.
A fall in disposable income and easy credit is likely to have a knock on effect on many retailers. Retailers have performed well in recent years, spurred on by the store card culture seen in Britain. As in the US, many UK consumers have been taking equity out of their properties and spending it on the high street, aiding profits further. But with property price growth faltering, this pattern is likely to come to a swift end, hurting the performance of retail shares and all those invested therein. The US could also have a further part to play in the state of the UK economy, especially if the housing recession seen over the water leads to a full US consumer recession. Such an outcome could heavily impact companies that rely on US sales. Tate & Lyle for example is a British company, but they derive around 40% of their top-line income from America.
What Can You Do to Protect Yourself?
If you are worried about how these problems are likely to affect you, you can check your portfolio's sector and stock exposures by using the free Instant X-Ray tool available in the tools section of Morningstar.co.uk (if you already have a portfolio on our site, you can access the same tool through our Portfolio Manager). The tool aggregates all of the securities in your portfolio and breaks down exposures to regions, countries, market-cap ranges, equity and bond styles, and economic sectors. You can also check if your allocations have shifted away from your original targets, or if you are more heavily invested in one asset class, stock sector, or even individual equity than you would prefer. If this is the case it could be time to rebalance your portfolio and reduce your future risk.
The current market outlook is uncertain to say the least, but this does not mean it is a bad time to invest. In fact, in hindsight, times of uncertainty have often been the best time to invest as stock prices are trading at large discounts to previous highs. However, if you are considering investing we would recommend a pound-cost averaging approach; this is in effect a way of drip feeding your capital into the market over a period of time. This method should help reduce much of the volatility that is plaguing the market at present. For more information please read The Benefits of Pound Cost Averaging article within the Fund ABCs section of our website.
