Result of financial imprudence

After more than a month & half long sabbatical, I am back. I really did not have enough time to write a new article due to several other commitments; however the present economic activities around us just could not let me watch things go by. For this article, I am possibly going to overshoot my self-imposed limit of length of an individual article. So be prepared for a long one. But I assure you that this will not be boring!

Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Bear Sterns, Merrill Lynch, Washington Mutual, Wachovia… and the list goes on. What is going on? Why is this happening? What is the magnitude of the crisis? Most importantly when is it going to end?

As I had anticipated…

Before we start analysis, I would like to draw your attention to the fact that in my earlier blogs (Inflation & Gold series) I had mentioned about the possibility of something similar happening. I mentioned in the first article of the Gold series “USD itself may lose it’s poster-boy image in International monetary system. In the short term, chaos that may be created, if this really happened that is, Gold will certainly hold more than equal status.” Things really have gone bad since then. To be honest when I wrote those articles in past, I never anticipated things to worsen so fast. I was in fact looking at a 6 to 12 months timeframe.

Size of the current crisis

Around March to May’08 timeframe, multiple press reports suggested that the crisis was about to get over. Example here. However we are here now. One wonders just how big is the size of this crisis. You must have by now known that US Govt. has announced official figure of $ 4.3 trillion being lost by the various US financial giants. On top of that, just yesterday US Congress passed the $ 700 billion financial bailout package for shoring up the tumbling stock markets & money market. Both these figures together amount to $ 5 trillion!! (Of course there could be some overlap between these 2 figures – 4.3 & 0.7 trillion). We all have known from past experiences that there is always a tendency on any Govt. to not tell the whole truth in one go. This to me means that the real problem is much bigger than this figure alone. On a separate thought, I think Govt. may have been telling the truth; it’s just that they are also most probably searching for more information!! That’s the worst situation to be in.

Anyways, back to the size of this debacle – this known figure of $ 5 trillion alone translates to more than 36% of the GDP of USA! And to me, it’s far from over yet.

One more statistic may throw some more light on the gravity of the situation. Some of the financial institutions that went bust in last few months, had successfully weathered & survived the biggest ever depression in the history of USA – The great depression of 1929! And those financial institutions were wiped out with one clean swipe in just under 1 year!

On a slightly different but related note, I would like to share some data on US National debt. David Walker – Comptroller General of USA (http://www.gao.gov/) mentioned in one of the broadcasts that USA currently has close to $ 8.3 trillion dollars in national debt. He forecasted that at the present pace of events (Govt. expenditure & revenue), by 2040, the net federal interest liabilities will almost equal the yearly tax revenues of the Govt.!

Why did the current crisis even start?

So this is big. Beyond any doubt. But why is it happening? I think all of you must have read several reports about the sub-prime crisis in multiple media reports. I don’t think it is worthwhile to repeat the whole story here. However I will bring up some highlights.

The upward move
For many years US interest rates were too low. That has encouraged US residents to invest in housing & real estate in general using borrowed funds. This goes for prime (creditworthy) as well as sub-prime (not-so-creditworthy) borrowers. Since the sub-prime borrowers are charged higher interest rates, the financial institutions wanted to take advantage of the situation & started lending more & more money to these borrowers. In the process, the financial institutions (FIs) created derivatives out of the securitization of the sub-prime loans. The derivatives increased the exposure of the financial system at a much bigger extent than the loans alone (please contact me if want more details for understanding this better). At the same time, the FIs started following non-prudent policies for taking higher exposure to such risky assets (sub-prime loans). This had a snowballing effect. As more & more easy funds were available to sub-prime borrowers, they started to borrow more & more. The more the borrowings, more the demand for real estate. The real estate prices started going up. Obviously even the Prime borrowers started to get cheap funds & they added to the real estate frenzy. The prices sky rocketed & kept moving up in last 15 years.

The downward journey
And sometime in last year, the inevitable started to become a reality. Many of the risky borrowers started to default on their mortgage commitments. FIs were forced to start foreclosures on these loans; which meant that there was more real estate added to the supply stream. As the supply started slowly overtaking demand, the prices obviously started falling. So for the borrowers who had entered in the real estate market at high prices, the current prices started looking unattractive. People even started to think if they really want to continue with the real estate at the current low prices while their mortgage payments are still at the higher points. More & more foreclosures started happening. Yet another snowballing effect but now in reverse direction! Now the prices started falling more & more sharply. This ultimately impacted the health of the assets of all FIs that had exposure in this market.

A few statistics would help understand the extent of exposure - 5.3 trillion sub prime loans were disbursed 2004-07. 10 trillion total outstanding (including sub prime & prime) by Q108. Which means the ratio of sub-prime to prime assets is almost 1:1. Before that, the ratio of sub-prime to prime was 1:5!! The exposure by FIs in sub-prime was too greedy & too imprudent. The snowballing effect continued & now the death nail was driven – Prime loans delinquency almost doubled in last 1.5 years!! This is how we ended up with the current mess. The single root cause in my opinion is greed!

Where are we? When is it going to end?

Is this over yet – I wish it were; however I know we are not done yet. We have been witnessing a lot of distress in US financial markets. A lot of FIs that have tumbled are from US. However the exposure of big European FIs to the sub-prime & mortgage derivatives is still unknown & it is unfolding slowly. Fortis in Belgium went down. A few signs of distress in Ireland are seen. I am more worried about the Swiss banking system. Some of the big names like UBS, Credit Suisse etc. These Swiss banks hold deposits equivalent to 6 times the Swiss GDP!! Their exposure to the current crisis would be the final blow!

So what is going to be the economic situation going forward? The current world Monetary system revolves around US Dollars. US financial systems overly encourage the residents to spend beyond their means (by keeping low interest rates & following imprudent practices). This means the demand from the US for goods & services produced by other nations goes beyond their national income thereby giving rise to negative balance of payments. Since USD is the currency of the world economy, USA can pump in additional $ in the system without those amounts being backed by any solid assets (like Gold or natural reserves). All this USD supply without good asset backing has been surviving purely on trust, faith & fear. Fear on part of other nations because other nations know that if the US economy falls, they will not be insulated either. In any case what is money anyways? It is just a medium of exchange on which people trust! Why do you need money? Money by itself is not the end, but the means to an end. We ultimately want to fulfill our needs through money. What if the things that we need are available to us? Would we then value money at all? Do you need money if you have things that you need? More on this in later articles. The point I am trying to make is that with the nature of the current crisis, USD dominance on the world monetary system will wane slowly. The monetary system may slowly try to find a new equilibrium.

Explanation of recent movements in Gold & oil prices

Most of the traders in Oil market seem to have receded their speculative activities & that has a huge bearing on the fact that crude went down from $ 140+ to it’s current level of around $ 90 per barrel. Besides this, liquidity crunch, economic crisis slowing down various economies & hence their expenses, the fact that development work for Olympics is over have had drastic impact on crude prices. All of this was expected to bring Gold prices down proportionately if we look at the past correlation between Gold & Crude. However that did not happen. In fact in last 4 weeks, a rare event has happened - gold broke correlation with crude! In last 2 weeks or so, in fact the Gold has shown signs of an upward movement. This fact is a clear indicator that speculators/ investors/ general public have gained more faith in the precious metal.

What are implications for India & other emerging markets?

If in general USD is supposed to be weak due to the financial crisis, why then is Indian Rupee depreciating sharply against USD? This must have been one of the questions that many of you would have thought about. The explanation is that a lot of Foreign Institutional Investors (FIIs) have been sitting on huge profits from Indian stock markets. Now they need to save themselves elsewhere in the world for their exposure in the current crisis. Hence they are now selling off their Indian assets & trying to repatriate their earnings after converting those into USD. Naturally, this has increased demand for USD v/s Indian Rupee.

For India, the ramifications are mixed. In the short term Indian economy too will be affected due to the financial ripple effect. However I feel India has greater potential to rebound in the long term. I don’t expect the financial crisis to hit India directly since Govt. has retained control over capital allocation through the Indian banking system. The current financial crisis in fact sets back the case for further financial reforms in India. Though there will be an indirect impact in the short term, world needs to find the bright spots once the current crisis starts to end (maybe another 2 years). There are not too many bright spots. I think India is still one of them. The urgency with which the nuclear deal between USA & India was passed is a strong indicator of how USA looks at India market.

What are the implications for individuals like you & me?

If you had been prudent over last few years by arresting wasteful expenditure & avoiding going overboard with credit, then you are probably in good shape. One who has cash or liquid assets in hand in these days is going to rule. There would be multiple opportunities where some distress assets will be available at a very attractive price. The ripple effects of financial crisis will impact other assets such as real estate etc. So keep cash ready for such distress opportunities, next 2 years will throw all such opportunities. Be very prudent. Don't borrow & buy, avoid wasteful expenses like cars & luxury goods that have low resell value. Look for bargains – you will get those. I am looking for some white goods corporate or an electronics retail chain to go bust or turn into distress sell mode so that I can buy my side-by-side refrigerator attached with HD TV! :-)