Wednesday, November 26, 2008

The Global Financial Crisis: Part 2 - The Bubble bursts

(published in DNA Navi Mumbai - 26/11/2008)

The easy lending practices to subprime borrowers on home mortgages started resulting in defaults and foreclosures in the US.  The number of defaults started increasing significantly in 2007.  Our friend John Smith who got the NINJA loan, realizes that he cannot afford to make the repayment.  He goes to the bank, returns the key to Uncle Banker and walks away.  In the US, home loans are without recourse, i.e., banks can only repossess the house.  Unlike in India, they cannot pursue the borrower for the balance payment on the loan.  An additional incentive to borrowing for owning a house, and negotiating very long term mortgages.

John Smith’s loan is foreclosed and his house put up for sale. Several such houses started entering the market in 2007.  Now, when supply increases, especially of distressed assets, the price has to drop.  So home loan prices started dropping.  Once prices started dropping, a lot of people who saw the value of their house drop significantly below what they had signed up to pay as mortgage payments defaulted.  This brought more houses to the market.  Which in turn increased the supply, which in turn reduced prices, caused more defaults…. you get the picture.

If this were a repeat of the US Savings and Loan crisis in 1989, it would have caused grief to a few banks who would have had to repent for their generously avuncular lending practices; there would have been a lot of hue and cry, along with demands for greater regulation and a few hundred small banks across the country would have gone belly-up.  Their depositors would have lost any of their deposits with a single bank above $100,000. There would have been a correction in housing prices along with perhaps a small impact on the overall economy.  People would have concluded that those who did not know what they were doing and lent to NINJAs had it coming to them anyway, and their shareholders deserved to lose some of their money.  That history repeated itself within such a short period of 20 years would have evoked a lot of comment and commentary, but would not have surprised those in the know of financial markets.  History has a way of repeating itself with monotonous regularity in the financial markets – it’s only the perpetrators and the minor details that vary each time.

History repeated itself with a twist, and an ugly one at that.  The securitization of the loans had resulted in the risk of default being passed on to millions of others in the market.  The amount of packaging, repackaging, bundling, collateralization, securitization and derivative transactions that had taken place with the housing loans as the base had spread so much within the system that no one knew who held what.  John Smith walking out of his house in Nebraska, resulted in several people losing half their retirement savings, people losing their jobs, markets across the world going into a tailspin, and the world entering into a recessionary phase.  On second thoughts, that is not a really fair comment – the risk caused by securitization was merely waiting to erupt, and the trigger was the housing loan defaults.  If it were not this trigger, sooner or later some other trigger would have caused it to erupt anyway.

There were lots of banks, mutual funds and hedge funds holding bonds whose income stream depended on these loans.  The prices of the CDOs that they held started dropping as the defaults in the housing market increased.  Mutual funds had to adjust their Net Asset Values (NAVs) to reflect the drop in prices.  Holders of units in mutual funds saw their holdings lose value.  Banks who held these securities had to “mark to market” their holdings, resulting in a drop in asset values.  The drop in asset values resulted in a situation of capital inadequacy, since banks are mandated to maintain equity of a certain percentage of their assets.  This resulted in banks needing money to recapitalize themselves. 

We have just spoken about the banks and the mutual funds.  What about our friends the merchant bankers, the ones who borrowed heavily from the market to invest in the securities which they helped create and hype up? If you borrow up to 30 times your net worth and invest it in a certain class of asset, and that asset class loses value, what happens when the asset value drops even by, say, 20%?  You have lost six times more money than you own.  That’s what happened to them. They lost several times their net worth, and it was all their creditors’ money.  The so-called AAA companies to whom people lent without security, believing their money to be as secure as with the government, were bankrupt, or nearly so.  Bear Stearns was about to go under, when the Fed brokered a deal with J P Morgan who bought it at fireside sale prices.  This was in March 2008.

Banks and other institutions who lose money in one area need to sell other available assets to make up for the shortfall.  They started cutting back on their lending.  They of course stopped subscribing to further CDOs backed by home mortgages.  They started calling back some of their loans made to other institutions.  Credit in the economy started becoming tighter.  They also started selling stocks. They sold stocks not only in the domestic markets but in the international markets as well.  The merchant banks and other institutions who owed them money in turn had to start selling their stock holdings both in the domestic and international markets. 

Stock prices started falling.  This resulted in equity mutual funds seeing a drop in their NAVs and hedge funds seeing their portfolios shrink.  A lot of investors started pulling out their money from these funds. This increased redemption pressures on these funds, which had to sell more stocks to obtain money to pay the redemption calls.  The fall in prices triggered computer trading models to place sell orders.  All this resulted in stock prices falling steeply which resulted in more sales, which resulted in more drop in prices, which … by now we are familiar with this cycle.

What happened to AIG in the meanwhile? They had insured a lot of the CDOs against defaults and they started to get calls against these defaults.  They had to recognize the greater risk of all the insurances they had so liberally handed out.  This resulted in actual outflows due to payouts as well as fresh collateral requirements.  One of the most solid and respected insurance companies of the world was in deep trouble. Insuring millions of houses across the country against an earthquake is based on the premise that when disaster strikes, it does not strike the whole country at once.  Insuring millions of CDO’s against defaults is a bad idea, since when disaster does strike, they all go under at the same time.

Lehman Brothers, another big ticket Wall Street merchant bank, went out looking for suitors while it was on the death bed.  It found none, and applied for Chapter 11 bankruptcy protection in September, 2008.  This was the one exceptional case where the Fed didn’t play broker to arrange a marriage.  No one really knows, but Hank Paulson, the US Treasury Secretary, could have harbored a grudge against Lehman. 

Other established institutions in this sordid saga have succeeded in selling themselves to other institutions or have been taken over by the government.  The justification offered by the US government is that they are “too big to fail”.  Their failure would have caused such ripples in the system that the fallout would have been unimaginable.  It would also of course have been catastrophic for those in power at several governments in the world.

The fall of Lehman did have huge consequences.  Whoever had lent to Lehman of course suddenly saw their chances of getting back their money evaporate, or at best, saleable for a few cents to the dollar.  Apart from direct money from institutions, there were also thousands of individual investors who had invested in structured products created and marketed by the financial geniuses at Lehman.  These structured products, like any of their kind, were very fancy complicated derivative products built around the performance of underlying benchmarks like the Dow.  What people do not realize or probably ignore, in the hoopla surrounding the marketing of such products, is that structured products are essentially unsecured debt with uncertain returns and risks that are not well understood.  The risk most ignored is the risk of the issuer himself going bankrupt.  There were a lot of derivative contracts where Lehman was a party to the deal, that suddenly were worth nothing.  The securitization, packaging, and bundling of financial products had reached such a level that people are still trying to figure out who lost how much due to the Lehman collapse.

Stock markets around the world had dropped significantly in September from their January levels.  The Sensex was around 14,000 after reaching a high of 21,000 in January.  Investors who saw the Sensex rise from a level of 3000 in April 2003 to seven times that in five years, suddenly saw a drop of 30 percent in a few months’ time.  The fall in the Sensex was attributable to growth projections moderating due to a slow down in the world economy, deleveraging and tight money, as well as major redemptions by foreign funds to meet their domestic redemptions and capitalization requirements. The pulling out of money also resulted in the rupee starting to appreciate significantly.  However, there were no CDOs and excess leveraging issues to deal with in the Indian economy.  The cautious regulatory framework followed by successive governments, a lot of which was due to political paralysis induced by their allies in the left front,  and the cussedness of the Reserve Bank in refusing to “accelerate” financial reforms, saved the economy from what would have been a disaster of great magnitude.  India still does not allow full scale capital account convertibility.  The RBI had not allowed banks to borrow from other banks and institutions more than a certain percentage of their net worth, thus restricting excess leveraging.  Clampdown on certain “bubble” sectors like real estate had already been instituted with strictures on excessive lending and more stringent capital requirement norms against such loans.  Times were difficult, and the signs were ominous, but the worst was over, or so most people wanted to believe.

The worst was yet to come. 

In September 2008, the same month that Lehman Brothers filed under Chapter 11, Merrill Lynch was taken over by Bank of America.  The Wall Street firm which was known for its aggression and derring-do even among other Wall Street firms, which had a charging bull for its logo, had to sell itself to prevent a bankruptcy filing. Goldman Sachs and Morgan Stanley announced that they would be converting themselves into bank holding companies, losing their investment bank status.  This way they would be leveraging themselves far less and be under greater regulatory scrutiny in return for government assistance. Several icons of Wall Street all fallen in a single month; the casualty list was growing.

The government announced a bailout package for AIG, and took over the ownership.  Fannie Mae and Freddie Mac were also similarly taken over.  Wachovia, a large bank with substantial retail presence got acquired by Wells Fargo.  Due to the vicious cycle of asset selling, price dips, and further selling, bond and stock prices started crashing across the world.  

The US government announced a bailout fund of $700 billion to buy out “distressed assets”.  After a lot of confusion on how this fund would be administered, Gordon Brown from across the Atlantic ironically showed the way.  Following his lead, it was decided by the US authorities that the fund would be used to recapitalize ailing banks and not to buy out distressed assets.  This was dole on a large scale, being handed out to people who least deserved it, in order to avert a world economic collapse.  Central banks across the world started cutting interest rates and announcing bailout packages for banks in distress.  

Panic set in across all markets.  Banks were unwilling to lend to each other since they were not sure whether their money would come back.  Being insiders, they were also the people who understood best that the whole industry was facing a crisis which could have weakened most of them. Overnight call money rates shot up to absurd levels.  Central banks announced various measures to infuse liquidity and confidence in the markets including reducing the deposit money that banks had to keep with them, announcing reductions in rates, increasing insurance guarantees on deposits, guaranteeing debt funds against default and arranging special credit lines for mutual funds who were seeing their NAVs drop and redemption pressures rise.  The Reserve Bank did all this as well.  It also announced relaxation of the curbs on investments of FII’s through Participatory Notes, thus effectively doing away with know-your-customer norms.  Desperate measures all, launched with a hope and a prayer, sandbags being thrown on the seashore to keep the tsunami waves at bay.

The heavy injection of liquidity was considered essential to stave off certain economic crisis.  Governments across the world wanted to avoid a repeat of the 1930’s kind of depression that the US went through.  On news of this kind the markets used to recover  somewhat; only to sink again within hours on receipt of another set of bad news.  The period from September to now has seen extreme volatility in stock markets across the world.  They have all sunk to record multi-year lows and are yo-yoing within a wide range right now.  The Sensex is wildly gyrating – it is likely that it will keep fluctuating madly between 8000 and 11000 levels for the next few months, before starting to go up again.

The inquiries and the witch hunting have of course started at the same time.  Alan Greenspan was hauled before a committee where he admitted, or was forced to admit, that the cheap money policy that he followed to stimulate economic growth may not, on hindsight, have been the best thing to do.  Hedge fund managers like George Soros and Philip Falcone who to the dislike of all made a lot of money betting on the markets in 2007, are right now being hauled up before some committees in Washington to depose, and presumably to express contrition for their moneymaking skills.

Stock regulators across the world, including SEBI, have found their new villains in short sellers.  They have taken measures to ban short selling.  Buying long or selling short are bets taken by speculators who take a call on the market, and help in infusing liquidity into the market.  They put their money on the line while placing such bets.  Restricting short selling is a completely knee jerk reaction to the crisis, like putting band aid on a festering wound and pretending that it would heal.

How is the common man and the establishment reacting to this?  The common man, poor chap, is suffering from acute shock.  In the US, the 401k savings invested in equity mutual funds are down 50% forcing people to plan to work till 95, home values have dropped, and jobs are not easy to come by.  There is a significant economic downturn due to markets shrinking and credit drying up.  Citibank has just announced that they would be laying off in excess of 50,000 people, by early 2009.  People from troubled institutions are out in the market looking for jobs. This situation is expected to continue for the near foreseeable future.  Job losses are mounting.    In India, several sectors are facing trouble, including IT and outsourcing, real estate, commodities, shipping, and travel and entertainment.  Layoffs have begun to be announced.

Europe and Japan are in a recession. The US is likely to enter into a protracted recessionary or slow-growth phase.  Several stock markets in the world do not open for days fearing imminent meltdowns.  The property market which had witnessed an unprecedented boom for the last four or five years is melting.  All growth projections for most industries across the world have been revised severely downwards.  India and China have also seen downward revisions of growth projections – GDP growth in India is expected to slow down to 6% levels from the earlier projections of around 9% - which is still good news since these two economies are at least growing.

The Sensex is currently at 9000 levels, down from 21,000 in January, 2008. The pulling out of FII money has also resulted in the Rupee depreciating to Rs.50 to the dollar, from Rs. 39 levels a few months back.  Companies in sectors depending on exports of goods and services have seen a drop in profit projections and share prices, though to a certain extent offset by the depreciation of the rupee.  IT, ITES and garment companies have seen significant erosion in share values. Companies in sectors which depend on leverage and rising asset prices are in trouble.  Real estate companies are in the doldrums and all set to default on their loan obligations.  Infrastructure and logistics companies have seen severe correction in share prices.  Sectors that depend on general economic activity being robust have been affected. These include hotels, travel and entertainment industries.  Though no company or sector has been spared the meltdown in share prices, there are some sectors which have withstood the shock better than others. These include FMCG and Pharma companies, the so-called defensive sectors, which depend on the India growth story which still has some steam.

The media coverage has of course resulted in further confusion and panic; the local paanwala is talking about the global economic crisis.  Sentiment rules, and the prevailing sentiments are fear, panic, and confusion.

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