Will the world come to a spectacular and disastrous financial end? Credit markets across the globe, which were flush with liquidity not too long ago, are in a limbo as inter-bank borrowing stands frozen after a series of prominent write-downs, insolvencies and collapses.Suddenly, it’s clear that everyone and everything is connected. This connection is due to the frictionless flow of capital across the globe. But while a crisis in leading economies can spill over to the rest of the world, the bubble itself cannot be attributed to this ‘connectedness’. What the bubble truly needed to ‘inflate’ beyond all expectations was the age-old artificial booster of purchasing power: leverage. And it is this leverage that lies at the root of most of the evils that threaten to disrupt the global financial system.In many ways, India presented the globally leveraged punters with a near-perfect investment story. Here was a nation of a billion people. A nation that was always brimming with talent but had somehow not managed to find its place in the sun. A cheap and seemingly unlimited supply of talented labour, a huge hinterland and mega-cities hungry for the creation of physical and digital infrastructure. A consuming class larger than the population of the United States.
Income expansion, capital expenditure, infrastructure creation and the resultant consumption boost were the themes driving the ‘India story’ over 2003-7. Mutual funds garnered record inflows, even as the FDIs and portfolio investments by foreign investors soared. The result wasn’t difficult to predict: an overvalued stock market, which, by January 2008, was assuming several years of future growth as if it was assured.The only saving grace is that India’s economy, as well as its financial markets, are not as hopelessly overleveraged as those of the West. Capital adequacies at most banks are in double digits, and many leading corporates are actually cash rich rather than debt burdened. The ones that are ‘leveraged’ (prime examples would be debt-heavy real estate companies, or investors with ‘naked’ derivative positions in the stock market) would, of course, be susceptible to disproportionate losses in any downturn.While there is no denying the fact that an unprecedented phase of economic growth has been initiated, stock markets can take a long time to recover from the shock of largescale selling by FIIs and hedge funds. This is because Indian stock markets have, for some time now, relied more on foreign investors than on local institutions for emotional anchoring. The ‘main street’ might continue to struggle forward somehow, but the ‘financial street’ will find the going tough as overseas risk appetite refuses to reappear.The BSE Sensex has crashed through the psychologically important 10,000 floor and is down more than 55% from its January 2008 peak. Corporate earnings are being downgraded almost on a daily basis, while sustained FII outflows take the wind out of every rebound. Worse, GDP growth downgrades are beginning to happen almost every week now. Interest rates are refusing to fall back, reducing the consumers’ appetite to buy assets such as homes, vehicles and appliances. Capital spending by companies and development spending by government is slowing down and the job market is awash with supply.So, who exactly are these overleveraged players? Start with the sub-prime American home-owner, who ‘leveraged’ by taking on a mort-gage that he could not normally service, in the hope of home prices rising forever. Investment banks then packaged these mortgages into collateralised debt obligations (CDOs) bundles and helped banks trade them out, so they could go back and create even more mortgages. In turn, this drove up the bank leverage and home prices in a self-fulfilling virtuous cycle.The smarter investment bankers set up hedge funds and leveraged their funds using cheap yen loans to buy (and re-sell) more CDOs. Even smarter bankers then created contracts (credit default swaps—CDS— another sophisticated example of the leveraging effect of derivatives) that would guarantee such loans so that buyers could buy and sell them even more recklessly. Result: the CDS market is over $50 trillion today, which is over 3.5 times the annual US economic output and roughly equal to the global economy.American householders, already on steroids with seemingly perpetual home-price surges, merrily increased consumption by taking on more and more credit. The goods and services they consumed were provided by the factories of China, India and other Asian tigers. In turn, these economies experienced a multi-factor boom.
All this propelled the world into a commodity bull run it had not seen for decades. Oil rose from under $20 to over $140 per barrel in five years or so, resulting in a transfer of wealth from commodity importer countries to exporters. Most commodities have had spectacular bull runs aided by leveraged hedge funds that took deep positions, and rolled over their contracts month after month, while increasing consumption in the physical world kept demand sufficiently high to justify such prices.
The tipping point came when the first defaults and write-downs were reported in the sub-prime CDO bundles that were being traded with wanton zest by investment and other banks. Soon enough, the writedowns began to affect prices (and trading volumes) across the CDO market. Prices of CDOs crashed and trading volumes dried up, aggravating an already painful situation. Soon, the write-downs on CDOs pushed investment and commercial banks into a dangerous situation where their capital was no longer enough to back even a small fraction of the risks on their books.
And,in a perverse response to this information, the short-term money market dried up. No bank would lend to another. The virtuous cycle turned vicious. Credit markets froze in a matter of days. Bond values crashed and write-downs drove several investment banks and hedge funds into MTM losses that proved larger than their shareholder funds. The result: bankruptcy and rival (or government) takeovers in some of the largest names in the business. Bear Stearns, Lehman Brothers, Wachovia and AIG fell one by one, in a bizarre domino-like sequence that left global financial markets gasping.
The evaporation of risk appetite took its toll on the hitherto rocking but ‘connected’ stock markets of China, India, Brazil and Hong Kong, with FIIs and hedge funds adopting the ‘rush home’ policy in response to their own liquidity problems. Currencies fell in response to this outflow, further exacerbating the pain for those who had chosen to stay invested. Local investors and funds, again with leveraged positions in the futures and ‘funded’ segments, were caught napping and suffered enormous losses. Their margin calls triggered further sales, driving down markets even more.
In San Francisco suburbs, falling home prices are pushing distressed borrowers into penury. Local banks from California to Massachusetts are on the verge of financial collapse as the frozen short-term money market refuses to thaw in response to the government-sponsored $800 billion bailout. The biggest investment banks, insurance companies and mortgage lenders are either dead or are being desperately revived from a coma. Along with spectacular hedge fund losses (largely arising out of the sub-prime mess), Americans have lost trillions of dollars of stock market wealth.Even after the hastily announced (but welcome) relief measures across Europe and the US, credit markets (the lifeblood of trade and commerce) refused to open up, pushing these economies closer to not only a recession, but financial breakdown. As we go to press, we can only worry about whether this is only the surface of a greater financial gridlock. Or whether the infusion of capital, loan funds and deposit insurance by governments will ease the pain.As credit shrinks around the world (most of it is due to de-leveraging and winding down on the ‘financial street’), a lot of good credit (related to the ‘main street’ business) will contract and disappear along with ‘bad’ credit (which was a contributor to pure financial leverage). Many innocents will be run over in this purging, putting the world economy on the backburner for quite some time. It was a great party, while it lasted. It’s time now to clear the mess. Will regulators use this as a final opportunity to control and tame leverage, that perennial enemy of discretion? If not, this is only the beginning of the end.We’ve already seen how this can affect us in India. So, as a small investor, what should you do now? It’s time for value, rather than growth, to be the yardstick for stock picking. As it is for keeping equity at modest levels (as opposed to aggressive) in your overall asset allocation. For those who are already heavy on equity, it may not make sense to withdraw this late; so park incremental wealth away from the stock market. And take some harsh switch decisions on existing portfolios.
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