U.S. Subprime Warming Is Not a Risk Mitigation

The repercussions of the international financial crisis that the U.S. subprime crisis triggered still exist. However, the ringleaders of the crime — subprime mortgage bonds (subordinate debt) — have recently warmed up, catching the market’s attention. The latest numbers from Bloomberg show that from June 2009 to the end of April 2011, the value of U.S. subprime bonds increased 43 percent and individual bond prices rose over 60 percent. Subprime bonds have become an important investing target for long-term investors.

After the outbreak of the international financial crisis, more people became aware of the high risk that occurred from financial leverage and the U.S. real estate market entered a de-leveraging process. Because those in the real estate business had to sell assets to pay off their loans, real estate prices and the scope of real estate transactions tumbled. At the same time, real estate credit also underwent an interval of negative growth. The price of U.S. subprime bonds, however, deviated from the related trends in the real estate market, appearing to experience a continuous upward trend, even receiving favor from long-term investing.

Excess liquidity is the root cause of the price rebound of subprime bonds. After the international financial crisis, the U.S. pushed an unprecedented rescue plan: two rounds of quantitative easing and a 0-0.25 percent benchmark interest rate, causing the U.S. financial system to have excess liquidity. Excess liquidity is bound to be configured into various investing schemes, and so even though the yield on subprime bonds has fallen from 10 to 15 percent to today’s 5 to 7 percent, it is still higher than the 3 percent yield of the 10-year U.S. treasury bond and has become investors’ way of increasing yields in their portfolios.

The law of supply and demand is another important factor in the rising price of subprime bonds. In an environment where capital is abundant, subprime bonds are an important part of investors’ strategy to increase yields. High-risk investors also continue their investments, causing an increase in demand for subprime bonds. At the same time, in the post-financial crisis era, the financial systems of developed economies had to be de-leveraged while their risk management strengthened, and thus the supply of subprime bonds shrank dramatically. Under the pull of high liquidity and a gap in supply and demand, subprime bond prices persistently increased.

As can be seen, this turn of increased subprime bond prices is supported by high liquidity, but this kind of support is unstable. On May 11, after the U.S. Federal Reserve announced an auction of $31 billion in subprime bonds, the price of subprime bonds and related bonds fell significantly.

If the subprime bond market wants a stable recovery, then it must still rely on the real estate market. However, the U.S. real estate price index has been falling. The S&P index of housing prices in the 20 largest cities in the U.S. showed a slip of 1.1 percent from February to the end of April, the lowest in 16 years. Additionally, the continued increase in foreclosed homes has also put pressure on the real estate market.

The price increase of subprime bonds does not originate in the recovery of the U.S. housing market or a returned boom in the credit market, and it is certainly not due to freedom in financial risk. U.S. financial risk is not to be ignored: for one, real estate prices continue to fall and risk in the real estate credit market is accumulating. Second, the freedom of liquidity has created an artificial economic expansion. For example, staple goods prices have risen sharply and subprime bond prices are artificially high, which could trigger a new financial risk. Third, the U.S. Federal Reserve is currently the largest debt holder of the U.S. financial market, and the pressure of having assets such as subprime bonds on its balance sheet is becoming more evident. Fourth, the U.S. government’s deficit and the level of public debt continue to climb higher, indicating that the country will face high national credit risk. In short, the warming of subprime bond prices is not an indication of freedom in the U.S. financial risk. Rather, vigilance is needed.