Market overreacting to sub-prime: CIBC

America’s sub-prime mortgage folly has spread uncertainty throughout global markets, driving investors to finally re-examine their risk tolerance. But a new study suggests the market has overreacted.

While rising interest rates earlier in 2007 resulted in immediate market turmoil, there have been warnings that the real catastrophe will not occur until 2008, when the bulk of low interest mortgages will be reset to a higher rate.

Mortgage defaults will continue to rise, says Benjamin Tal, senior economist with CIBC World Markets, but the impact on financial markets may not be as bad as current valuations suggest.

“It turns out that not only did the barrage of negative headlines of recent months raise the level of market immunity to adverse sub-prime news, but in fact, even after its recent improvement, the mortgage-backed market is currently pricing in a darker picture than the one likely to emerge when the smoke clears,” he says.

By the end of 2008, about $700 billion worth of sub-prime mortgages will be reset to a higher interest rate, after their introductory “teaser” rate expires. The default rate on sub-prime mortgages will likely rise to about 25%, while the market seems to have priced in a default rate of 30%.

Make no mistake — Tal’s prediction of a 25% default rate is no walk in the park. It is 35% higher than the default rate on mortgages taken out in 2000 in the Midwest, which at the time rated as the worst vintage for defaults.

But according to Tal, the current values on the ABX sub-prime-linked default swap indexes point to a default rate of between 28% and 32%.

“Those implied default rates are roughly 20% higher than our projection, suggesting that the market is currently pricing in a much more draconian outcome than our main case scenario suggests,” Tal says. “This means opportunities not only in the ABX space but also for the mortgage-backed security and equity markets as a whole, as the sub-prime default rate will not jump high enough to clear the bar set by the market.”

Whether the market is oversold or not, the latest MarketPoint report from Richardson Partners recommends a cautious approach to the markets, with an eye toward increased volatility.

The firm recommends investing in cyclical stocks — namely large caps in the energy, agriculture, tech and industrial sectors #151; for growth, with a dose of more defensive stocks in the consumer staples, life insurance and healthcare sectors to provide stability.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com