Financial crisis: Why bailouts are not the answer

Disasters and wars provide excellent opportunities for businesses to make money. Governments are in a mood to open the tap, there are fewer checks on decisions taken in a rush, and special interests can make merry.
The airlines who were hit by the 9/11 attacks seven years ago wrested big concessions from the government, though smaller businesses that were equally badly hit got nothing. A similar attempt in the United States has just failed, with the big American car companies failing in their bid to get a $50 billion bailout package -- which is just as well, because the history of such bailouts is not encouraging.

It is far better for the companies (which have continued to stress the production of gas-guzzlers because they are more profitable) to file for bankruptcy if and when they run out of cash, and then undertake the long-delayed restructuring of their businesses under creditor protection, as the airlines eventually did.
It is re-assuring in this context that the authorities here at home have moved carefully. When people argued that non-banking finance companies should not be allowed to fail, the government did not rush in with bailout packages. But the decision to raise the import duty protection available to steel can and should be questioned because steel prices are still too high, by historical standards, and downstream units need lower input costs if they are to cut their own product prices -- as the finance minister has exhorted them to do.

An unusual challenge has been thrown up by the foreign currency convertible bonds issued by companies. With share prices having fallen below the prescribed conversion rates for the bonds, and with many companies unlikely to have the money to buy back the bonds on maturity, the risk of corporate default is high -- and is reflected in the deep discounts at which these bonds are being traded.
There is an obvious opportunity here to buy back the bonds at the discounted prices. Less obvious is the wisdom of the move to finance this by issuing fresh bonds. Such financial engineering must be approached carefully. Spreads on foreign loans have gone up sharply, and will be even greater for companies facing repayment crises and those whose share prices are much lower than before. The net benefit therefore may be limited, and could even be illusory.

The RBI move to reverse an earlier decision that increased the risk weighting for real estate loans is another step that should be questioned. It cannot be that real estate assets have become less risky; although prices have come off their peaks, there are few transactions in the market and all indications are that prices need to dip further.
It is understandable that the RBI might want credit to flow into a frozen real estate sector, but risk needs to be correctly priced if banks are not to be placed at risk. The risk weighting for loans to farmers and to small and medium enterprises has also been lowered -- once again, prudential considerations seem to have been made subservient to the desire to address sector-specific issues.
On the evidence so far, banks are not lending to the troubled sectors because they have their own commercial judgment with regard to risk; indeed, lending rates in the market have dropped by much less than the RBI's benchmark rates, so the problem is that bankers are still careful about the quality of assets they take on.

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Avoid your own financial crisis

Most investors have been too psyched out by the mayhem in the global financial markets and its crippling impact on their investment portfolios to take note of the lessons that the crisis holds for them—that poor decisions can land anyone, from large organisations to individuals, in a financial mess, and that this doesn’t take long to happen. For individuals, financial crisis can result from excessive borrowing, living beyond one’s means, poor asset allocation, under-diversification, medical emergencies, or even loss of employment. And it’s in deteriorating market conditions such as at present that individuals are made to pay dearly for such follies. Ergo, it’s important to work out a plan to stay in control and avert a financial crisis. Here’s what you should do.

Know your debt

We all need debt at some point. It can be a loan for a house, an automobile, education, or for other personal needs. But debts can be good, bad or ugly. Home loans are considered good debts as they are used to build useful assets. A home loan makes more sense if you want to switch from a rented to an owned house. And, the lesser the difference between your EMI (equated monthly installment) and rent, the more sense it makes to acquire a home. Says Sanjay Matai, Promoter, The Wealth Architect: “From the need perspective, it is prudent to borrow only for good loans and not to exceed certain limits.” Personal loans are “bad” debts, which should be availed of only in dire circumstances. Ugly loans include credit card debts that are used to finance consumption or luxuries. Both these loans come with high interest rate liabilities and should be avoided at all costs.

Borrow sensibly

Financial planners suggest that one should remain as debt-free as possible. If it’s entirely necessary, then one should borrow only to the extent one can comfortably. Says Viraj Ghatlia, Head, Financial Planning & Wealth Advisory, ASK Wealth Advisors: “When you borrow, you must compare the period for which you take the loan and its repayment schedule with future cash inflow projections. The inflows should always be far greater than the outflows since there can be other expenses besides servicing the loan.”

Normally, the size of down payment and EMI determines whether one can afford a loan or not. If you are taking a home loan, then look for a property for which you can make the down payment, which is usually 15 per cent of the cost of the property. Thus, you can go for a Rs 50-lakh home if you can pay Rs 7.5 lakh. Also, the home loan EMI should not exceed 40 per cent of your net take-home pay. In case of personal/credit card loans, the EMI should not exceed 25 per cent. When buying a home, you should ideally keep aside three months of funds (including EMIs and expenses) as a back-up.Says Gaurav Mashruwala, Certified Financial Planner, ACE Financial Advisory Services: “Do your own personal net worth calculation to keep track of your financial standing. This can be obtained by dividing the sum of all your assets such as money in savings or current account, NSCs, EPFs, property value, car value, stock value, etc., with total debts such as home mortgage, credit card balance, etc. Your total principal liabilities should not be more than 50 per cent of your assets

Don’t over-leverage

According to Mashruwala, overleveraging is a high-risk, low-return game. When you borrow for investment purposes, your net income depends on the returns generated from that asset class minus the interest paid. For example, X and Y invest Rs 5,000 each in a stock. While X invests his own money, Y borrows the same amount at the rate of 10 per cent annum. Let’s assume that over the next three years, the stock generates returns of 40 per cent. After three years, the net income for X will be Rs 7,000 – Rs 5,000 = Rs 2,000, but for Y, it will be Rs 7,000 – Rs 6,500 = Rs 500. Agrees Amar Pandit, Director, My Financial Advisor: “Borrowing to invest is a strict no-no.”

Watch your spending

Eliminating unnecessary expenses and saving prudently are the keys to sound financial health. To illustrate the virtues of saving, if you save an additional Rs 5,000 every month and invest it in a debt instrument that gives 8 per cent annual returns, it will grow to over Rs 17.5 lakh in 15 years. Says Pandit: “To reduce expenses, one can keep a check on entertainment expenses, cut down on the extra phone and look for bargains and offers while shopping.” Other ways of cutting expenses and increase savings are keeping interest payments on credit cards to the minimum, and even scaling up one’s income.Invest wiselyRegular saving and investing makes all the difference between hitting and missing financial goals. Says Himanshu Kohli, Founder Partner, Client Associates: “Every investor should balance wealth creators (equity and real-estate) and wealth preservers (debt) in line with his financial profile, investment objectives, risk appetite and time horizon. Try to put your money in investments that can earn you higher returns than the rate at which you are borrowing. This will help generate positive cash flows for you while servicing your loan.” You will be better off if you have emergency funds the size of 3-6 months of your monthly expenses to deal with unforeseen contingencies. Last, but not the least, buy mediclaim, accidental insurance, permanent disability and professional indemnity policies.

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What the world's big guns say about the meltdown

The financial crisis -- that has ravaged global markets, bankrupted many investment banks, brought about a tectonic shift in world economies, turned many a topcat into a homeless tramp and caused thousands to lose their livelihood -- is said to be the most horrific fiscal calamity ever to have visited mankind.
Worse, the full impact of this onrushing tsunami has not even been felt yet: experts promise more pain in the coming months and years. Pain that will take years to fade away.
And here's what the world's top leaders and economic brains have to say about the global meltdown. Read on. . .
We are right now teetering on the verge of panic: George Soros, billionaire investor, head of Soros Fund Management
The government's intervention is not intended to take over the free market, but to preserve it: George W Bush, president, US .
It's wrong to ask teachers, farmers and small-business owners to fill the gas tanks of the helicopters of Wall Street tycoons: John McCain, Republican presidential hopeful .
Washington has to recognise that economic recovery requires that we act not just to address the crisis on Wall Street, but also the crisis on Main Street and around kitchen tables across America: Barack Obama, Democrat presidential hopeful .
The Masters of the Universe have bitten the dust, the same dust that is now in the mouths of the rest of us. The impact on the developing world would be profound. Projects are already stopping because of the lack of liquidity and financing. The debt crisis would become worse. The decline in commodity prices and exports would hurt the developing world: Nirupam Sen, India's permanent representative at the UN .

I can say with certainty that if investment banks were still private partnerships, where the partners have all their personal capital at risk, the financial meltdown would never happen. They would not let another Lloyds of London capital call happen, ever: Mark Cuban, US billionaire.
The financial tsunami we now face is a global crisis. Its destructive force is much stronger and more widespread than the Asian financial turmoil in 1997. The recovery will take longer, be more difficult and certainly cannot be taken lightly: Donald Tsang, chief executive, Hong Kong .
What is the nature of the crisis? The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further: Economic Nobel laureate Paul Krugman.
What we needed and didn't have two or three weeks ago was a good diagnostic of the problem: It was not a liquidity problem; it was a solvency problem. And once you start from that position, the British solution is the only way forward: Philippe Martin, professor of economics, the Sorbonne, Paris
I'm a strong believer in free enterprise, so my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course, but these are not normal circumstances: George W Bush, President, US .

For the poor, the costs of the crisis could be lifelong. The poorest and most vulnerable groups risk the most serious -- and in some cases permanent -- damage. 100 million people have already been driven into poverty this year and that number will grow: Robert Zoellick, president, World Bank
Wall Street had it coming. . . The nature of America's financial crisis is the failure of Wall Street's business model in and of itself: Japanese columnist Hideo Tamura .
We live in an interdependent world and the fate of all countries is related to the international financial system. Our value markets are opened to the world and, if they are affected, this will affect our capacity to finance our development. If the financial crisis causes a recession in the main economies, this will compromise our exports: Manmohan Singh, Prime Minister, India
The age of Reaganism is over. The no-regulation, low-taxes philosophy has broken the back of our economy: Former Harvard University economist Jeffrey Sachs, now special adviser to the UN Secretary-General Ban Ki-moon
Where was the IMF? This is the sort of crisis that should be at the heart of what the IMF was set up to do, but no one in the U.S. or in other G-7 countries seems to turn to the IMF for advice: Mohamed El-Erian, co-CEO, investment firm PIMCO, and a former IMF economist who was in the running to head the fund four years ago.

Seeing big American banks saved by privatisations, one almost wants to scream, 'Marx, come back, they've gone crazy!' We're seeing, in renewed form, the most debatable aspects of Anglo-Saxon capitalism called into question: Arnaud Lagardere, general partner and CEO, Lagardere Group
I know too well how disastrous these slumps can be. During the 1991 recession I was basically bankrupt -- it all happens very quickly. So what's the use in finger-pointing? I don't want to see the Americans go down the pan. Everyone knows that we'll follow: Stephen Brown, British citizen
The financial world still has a number of serious problems. However, time and money will eventually heal them: Barton Biggs, Wall Street strategist
Although a great many policy actions have since been taken, they have been neither comprehensive nor global. Indeed, the approaches taken have been so varied and inconsistent, especially with regard to deposit guarantees, that they are intensifying problems for other countries: Dominique Strauss-Kahn, head, IMF
The situation is going to get better when you feel good about buying Citigroup stock. Right now, nobody feels good about buying it: John Catsimatidis, supermarket billionaire and New York mayoral hopeful .

It's a good warning for the Chinese economy, but I believe China will make the exact same mistake in future: Kelly Yu, Chinese citizen
You can't just blame the banks, you also can blame the people that took out mortgages... We were brought up that you first had to put some savings together and then enjoy. But this whole society has gotten to the fact that we're a 'now, give it to me today' kind of society. I think regulation has not been adequate. There's no one person to blame other than all of us: Mike Bloomberg, mayor, New York, former Wall Streeter, founder, financial services company Bloomberg
My own view right now is that cash is king; liquidity is king: Don Marron, US billionaire
The Wall Street crisis has been caused by the years of excesses and the fee-based economy where the only goal is to make fees at any cost without any benefit to the economy: Carl E Berg, US billionaire
We have counted on emerging economies, which collectively account for half of global GDP, to hold up. However, with the credit crisis reaching shores of emerging market countries, their growth is now likely to fall well below trend by the end of the year: Moody's Economy.com