What is happening during a risk repricing?

By Albert Phung AAA
A:

During a strong bull market, the market's overall sense of optimism can often lead to poor estimates about the level of risk that an investment may possess. Unfortunately, once a market correction occurs, investors will often realize that they have been exposed to more risk in certain investments than originally anticipated. Because higher risk investments yield potentially higher returns, the market goes through an adjustment period during which relevant investments will be repriced to account for the extra risk. This is know as risk repricing.

To illustrate, let's consider an example. Suppose that several insurance companies shift their efforts to primarily selling home insurance for natural disasters, which their models have forecasted as rare occurrences (such as hurricanes, tornadoes and earthquakes). For the first few years of this program, their forecasting models prove correct and payouts are minor. Subsequently, their stock prices soar due to record profits and their bonds receive high ratings. A few years later, natural disasters become more prevalent and new studies, reports and models indicate that these events will be far more common and destructive in years to come. As a result, the market realizes that owning investments in these insurance companies will be a large gamble, because the onset of a costly disaster could bring an end to the insurance companies' profits. Thus, the market will start becoming bearish on the company's shares based on the new risks they face. Similarly, any newly issued bonds from these companies will have downgraded ratings, and will need to pay a higher coupon because investors see a reasonable likelihood that the company will default.

A market correction also occurred in response to the subprime meltdown in 2007, when the market realized that its mortgage-backed securities (MBS), previously rated as investment grade, were far more risky than other 'BBB' rated bonds. As a result of this, investors demanded higher rates of return on any bonds that were tied to subprime mortgages. This shift was illustrated by the widening spread between riskless government Treasuries and commercial bonds, as investors demanded larger risk premiums for holding non-government debt securities. (For related reading, see What are the risks of invesing in a bond?)

Additionally, subprime mortgage lenders' stocks faced large share price declines, because the amount of financial risk that the companies held did not justify their valuations. Because their financial performance was in doubt and investors decided that their stocks were not good investments to hold onto, the market repriced the shares downward.

For related reading, see The Fuel That Fed the Subprime Meltdown.

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subrpime Mortgages Feature.)

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