Savers should weather the sub-prime storm

The storm surrounding American sub-prime mortgages has finally reached markets. What can and should an investor do?

There are some types of investment which will be more likely to feel the impact of the collapse of the American sub-prime mortgage market than others. Stock markets are suddenly more volatile than we have been used to and in some ways it could be argued that every quoted company has been touched. It is a reminder of the statement made by regulators that markets can go down as well as up.

As has already been demonstrated, many hedge funds have taken positions in the securitised debt market. Since hedge funds deliberately take risky positions and then add to that risk by using borrowed money, they have been the first casualties.

Hedge funds are not usually places for private investors and as such there will be a limited number who should be worried. Unfortunately, most hedge funds use a penalty clause to lock investors into the fund for a pre-set period of time and then only allow trades in their funds on one or two days per month. As such, any investors with holdings will find it difficult - at best - to sell and protect their money.

As hedge funds default or are bailed out, it is their lenders who are forced to assume the losses. In many cases, these losses will be concentrated on a small number of lenders. Over the last few months, Bear Stearns and Goldman Sachs, amongst others, have had to spend several billion dollars to prop up funds.

The real worry though is that there are many low risk funds around the world which may be affected if the American borrower continues to default. If this happens, there is the potential that virtually every investor on earth could be holding a small share of the losses.

Some well-known and very well-used investment strategies by fund managers are called cash matching, duration and immunisation. In brief, these theories aim to match investments in a fund with expected outflows of money. Some funds, most notably pension schemes, have known liabilities which must be met. These liabilities, such as the retirement dates and expected pension payments of employees might be known years in advance.

To limit the potential surprises a fund may need to deal with, fund managers find investments which will pay out on dates and in amounts which correspond to these expected cash outflows.

This means that an ideal cash matching investment will have very little price volatility, a known return on or by a known date and a low probability of total loss. In theory at least, US dollar denominated securitised mortgages fit the bill.

To help match their liabilities, collective investment income funds and pension schemes around the world will have been buyers. They will almost certainly have purchased the highest quality debt rather than the high-risk portions that many hedge funds are holding. However, as the initial risk ratings are made to look rather optimistic, it is difficult to judge what is actually safe. Luckily, pension schemes are experts at diversification and rarely use borrowed money for investment, so it is highly unlikely that there will be any funds failing.

So what is an investor to do? As most pension scheme members will know, it is not easy to make transfers or sales of holdings. In fact, for many, it will not be possible at all. Punitive scheme rules or tax legislation will almost certainly make this difficult.

For those of us that save monthly into a pension scheme, there should be little reason to stop or reduce these payments because of increased market volatility. The reality is that we each have a finite number of paydays from which we need to build a pension pot - this is not a good enough reason to stop saving.

The situation may be different for those contemplating a lump sum investment in the near future. Although the sub-prime situation has been building for many months, there will almost certainly be more fall-out spilling over into equity markets. Should that happen, prices will be forced lower. Buying opportunities will present themselves in time.

As for holders of direct equity investments, the sectors which are likely to face the most extreme price movements and potential losses are banking, insurance and fund management. Unfortunately it is virtually impossible to assess how much exposure - if any - individual companies currently have. The market will tell us in time.

• Stuart Langridge holds UK qualifications in personal finance. www.thestuartlangridgeletter.com

The storm surrounding American sub-prime mortgages has finally reached markets. What can and should an investor do?