When the bubble burst..

When the bubble burst


While some blame the greed of Wall Street investment bankers and the dangers of a totally unregulated system for the current financial crisis, what can't be denied is that lives, and lifestyles, have been suddenly changed across the social spectrum and careers built up over a lifetime have vanished in an instant. Apart from the revised $700 billion bailout plan, can the U.S. government do enough to restore confidence and assuage the trauma?


The real question is: Who is going to compensate the common investors across the world who have lost their wealth in the resultant market meltdown?


The bursting of the speculative bubble in the U.S. housing market has destroyed billions of dollars in investor wealth across the world, crippled the banking system, expunged close to a million jobs…and India has not been spared either. With banks failing by the day, definitely, these are uncertain times for the financial services industry. While many people who have lost their jobs are faced with permanent shrinkage of their lifestyle, others in the industry are going through the trauma of not knowing if and when their turn would come. Who is to blame?

Flashback to year 2003:


Rohit (name changed to protect identity), a good friend of mine and someone who was officially considered to be a genius with an IQ of 150+, graduated from one of the leading IIMs. Rohit managed to make it into the New York Headquarters of the most sought after firm that had arrived on campus for the first time — Lehman Brothers — a top U.S. Investment Bank (then). On joining, he was assigned to Lehman's mortgage securities desk that dealt with Collateralised Debt obligations (or CDOs).

Following is an extracted transcript of a chat session I had with Rohit back in 2004:

Me: So man, you must feel like you are on top of the world.

Rohit: Yes dude, the job here is amazing, I get to interact with people around the world, investment managers who want to invest millions of dollars

Me: Great…so tell me something interesting. What's your job all about?

Rohit: You know there is a great demand for American home loans, which we buy from the U.S. banks. We then convert these into what is called as CDOs (Collateralised Debt Obligations). In plain English, this refers to buying home loans that banks had already issued to customers, cutting them into smaller pieces, packaging the pieces based on return (interest rate), value, tenure (duration of the loans) and selling them to investors across the world after giving it a fancy name, such as "High Grade Structured Credit Enhanced Leverage Fund".

Me: Wow! I would've never guessed that boring home loans could transform into something that sounds so cool!

Rohit: Hahaha…actually we create multiple funds categorised based on the nature of the CDO packages they contain and investors can buy shares in any of these funds (almost like mutual funds…but called Structured Investment Vehicles or SIVs)

Me: Dude, you make your job sound like a meat shop…chopping and packaging. So, in effect when an investor purchases the CDOs (or the fund containing the CDOs), he is expected to receive a share of the monthly EMI paid by the actual guys who have taken the underlying home loans?

Rohit: Exactly, the banks from whom we purchased these home loans send us a monthly cheque, which we in turn distribute to the investors in our funds

Me: Why do the banks sell these home loans to you guys?

Rohit: Because we allow them to keep a significant portion of the interest rate charged on the home loans and we pay them upfront cash, which they can use to issue more home loans. Otherwise home loans go on for 20-30 years and it would take a long time for the bank to recover its money.

Me: And, why does Lehman buy these loans?

Rohit: Because we get a fat commission when we convert the loans into CDOs and sell it to investors.

Me: Who are these investors?

Rohit: They include everyone from pension funds in Japan to Life Insurance companies in Finland.

Me: But tell me, why are these funds so interested in purchasing American home loans?

Rohit: Well, these guys are typically interested in U.S. Govt. bonds (considered to be the safest in the world). But unfortunately, Mr. Alan Greenspan (head of Federal Reserve Bank, similar to RBI in India) has reduced the interest rate to nearly 1 per cent to perk up the economy after the dotcom crash 9/11attacks. This has left many funds looking for alternative investments that can give them higher returns. Home loans are ideal because they offer 4-6 per cent interest rate.

Me: Wait, aren't home loans more risky than U.S Bonds?

Rohit: We have made home loans less risky now. In fact they have become as safe as U.S Govt. bonds.

Me: What are you saying, man? What if the people who have taken these underlying home loans default? Then the investors would stop getting the EMIs, and their returns would take a hit. Wouldn't it?

Rohit: Boss, may be some will default, but not definitely more than 2-3 per cent. Moreover, we have convinced AIG (a leading insurance company) to insure our CDOs. This means that even if there were big defaults,the insurance company would compensate the investors.

Me: that's amazing. What are these insurances called?

Rohit: Credit Default Swaps.

Me: Definitely you guys are the most creative when it comes to naming.

Rohit: Thanks.

Me: And why has this AIG guy insured millions of home loans?

Rohit: See man, the logic is simple. Home prices in the U.S always go up. In fact over the last three years alone they have doubled. So even if someone defaults paying the EMI, the home can be seized and sold for a much higher price. So there is no risk. Insurance companies are actually competing to insure this, because they can earn risk-free
premiums.

Me: No wonder investment managers from all over the world want to put money in your CDOs.

*A global financial cobweb started getting built around the American dream of purchasing a home and it rested on the assumption that "home prices will keep rising". As demand for the CDOs started growing across the global investment community, the investment bankers (like Lehman) who were meant to sell these instruments also started investing a significant portion of their own capital in these. I guess after selling the story to the whole world, they themselves got sold on the seemingly foolproof concept. Gradually the markets for CDOs and Credit Default Swaps started expanding with traders and investors buying and selling these as if they were shares of a company, happily forgetting the underlying people behind these products who took the home loans in the first place and on whose capacity to repay the loans, the safety of these products depended.

As Wall Street firms like Lehman were churning more and more home loans into CDOs and selling them or investing their own money, there was a pressure on the banks to issue more loans so that they can be sold to the Wall Street firms in return for a commission. Slowly banks started lowering the credit quality (qualification criteria) for availing a home loan and aggressively used agents to source new loans. This slippery slope went to such an extent that in 2005, almost anyone in the U.S could buy a home worth $100,000 (45 lakhs INR) or more without income proof, without other assets, without credit history, sometimes even without a proper job. These loans were called NINA — "no income no assets".

The U.S. housing market went into a classic speculative bubble. Home loans were easy to get, so more and more people were buying houses. The increased demand for houses caused the price to increase. The rising prices created even more demand, as people started to look at homes as investments — investments that never went down in value.

When I touched base with my friend Rohit in late 2005, he was on cloud nine. During the previous one year, he managed to buy a home in Long Island (a posh area near New York City) worth almost a million dollars, and got himself a Mercedes. All this was interesting to hear, but what shocked me was that although he was earning close to $20,000
a month (that is what CEOs in India make) he was not able to save anything because his lifestyle expenses where growing faster than his salary.

Unheeded signals

In late 2006, Mortgage lenders noticed something that they'd almost never seen before. People would choose a house, sign all the mortgage papers, and then default on their very first payment. Although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped. Another factor
that lead to the burst of the housing bubble was the rise in interest rates from 2004-2006. Many people had taken variable rate home loans that started getting reset to higher rates, which in turn meant higher EMIs that borrowers had not planned for.

The problem was that once property values starting going down, it set off a reverse chain reaction, the opposite of what had been happening in the bubble. As more people defaulted, more houses came on the market. With no buyers, prices went even further down.

In early 2007, as prices began their plunge, alarm bells started going off across mortgage-backed securities desks all over Wall Street. The people on Wall Street, like Rohit, started getting calls from investors about not getting their interest payments that were due. Wall Street firms stopped buying home loans from the local banks. This had a devastating effect on particularly the small banks and finance companies, which had borrowed money from larger banks to issue more home loans thinking they could sell these loans to Wall Street firms like Lehman and make money.

Everyone got into a mad scramble to seize and sell the homes in order to get back at least some of the money. But there were just not enough buyers. The guys who had insured these loans thinking they had near zero risk (e.g. AIG) could not fulfil the unexpectedly huge number of claims. The best part was that since these insurance policies (credit
default swaps) could themselves be traded, multiple people had bought and sold them, and it became so tough to even trace who was supposed to compensate for the loss.
 
The global financial cobweb built around mortgages is on the brink of collapse. Firms, large and small, some young some as old as a 100 years have crumbled as a result of suing each other over the dwindling asset values. Lehman's India operations, that employed over a thousand staff, is up for sale and many of the employees have been asked to
leave. The Indian stock market has crashed almost 50 per cent from its high (and so have markets around the world) as the Wall Street giants sold their investments in the country in an effort to salvage whatever is good in order to make up for the mortgage related loss. Hedge funds, pension funds, insurance companies all over the world have lost
billions in investor's money. Many Indian B-School graduates with PPOs (pre-placement offers) in the financial sector (India and abroad) have either received an annulment or indefinite postponement of joining dates. IT firms that built and maintained software for the U.S. mortgage industry or the related Investment Banks, have shut down their business units, laid-off people or transferred them to other verticals.

Fragile system

For all the hoopla over the sharp and sophisticated people on Wall Street, the current financial crisis has exposed the fragility of the system. Wall Street is blaming the entire episode on people who could not repay their home loans. But the reality seems to point towards the stupidity of people who lent all this money, financial institutions that built fancy derivative packages and in effect facilitated billions in trading and investments in these fragile low quality loans.

The U.S. Govt is planning to grant 700 billion dollars to the Wall Street firms to compensate the financial speculators for the money that they have lost. Isn't this like rewarding greed and stupidity? The head of a leading Investment Bank has stated, "This is necessary to sustain financial ingenuity. We don't want to spend this money on ourselves. We just want this money to go into the market so that we can carry on trading complex securities, borrowing and lending
money." (Yeah…right, so that one can act as if nothing had happened without analysing too much into it). The real question is: Who is going to compensate the common investors across the world who have lost their wealth in the resultant market meltdown? (either directly or through pension funds).

After being unreachable for a month now, finally I heard back from my pal, Rohit, saying he is back in India to take a break from the roller coaster ride that he had lived through. After Lehman's collapse he has lost his job and probably the house that he had bought by taking a hefty loan. I really don't know whether to feel happy for him, for
getting an opportunity to learn a lesson or two from the experience or to feel sad for him for losing his job. May be I'll get a better sense of things once I meet him next week,

 

Courtesy: Rohit

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Investor wealth plummets by Rs 36,50,000 cr

 

NEW DELHI: The turmoil in the global markets has taken its toll on investors in domestic bourses which have suffered a loss of over Rs 36,50,000 crore in nine months since the benchmark Sensex scaled its life-time high on January 10.

Country's most valued firm, Reliance Industries witnessed its market capitalisation fall to less than half to just Rs 2,39,804.62 crore at the end of trading on Wednesday from Rs 4,40,046.42 crore on January 10.

The total investor wealth, measured in terms of market capitalisation of all the listed companies together, dipped to about Rs 36,50,000 crore on October 8 -- as against close to Rs 73,00,000 crore on January 10, when the benchmark Sensex scaled its life-time high before embarking on a southward journey.

In the dollar terms, the loss has been even bigger as rupee has also depreciated sharply against the US currency.
The cumulative market capitalisation of Indian companies stood at 1.8 trillion dollars on January 10, which today came down to 760 billion dollars, as rupee fell from 39.26 per dollar to near 48-level today.

Other blue chip firms which lost heavily during the nine months period include ONGC whose market cap dropped by over Rs 70,000 crore in the period and telecom major Bharti Airtel's witnessed a loss of over Rs 44,000 crore in the period under review. While country's largest lender SBI has lost close to Rs 69,000 crore in its market capitalisation since the peak in January till October 8.

The 30-share index, on Wednesday, fell to as low as 10,750.76 points -- its lowest in more than two years --before ending the day at 11,328.26 points after some recovery.

In the overall loss of close to Rs 36,50,000 crore, the company promoters have seen an erosion of over Rs 20,00,000 crore with their holding of about 60 per cent.

After promoters, FIIs have taken the biggest hit with a loss of over Rs 4,00,000 crore, while retail investors have lost more than Rs 3,00,000 crore. The banks, mutual funds and insurance companies have also seen the value of their holdings plunge by close to Rs 3,00,000 crore.

Attributing the fall in stock markets to happenings in the US and other Asian markets, Finance Minister P Chidambaram has cautioned against any hasty decisions by investors as fundamentals of the Indian economy are strong

 

http://economictimes.indiatimes.com/Investor_wealth_plummets_by_Rs_3650000_cr/articleshow/3577591.cms

Impact of global slowdown on Indian economy

I am not usually a pessimist. But I predict that India will suffer a lot of pain in the next 18 months, as the economy slows down along with the current global slowdown.

The US, Europe and Japan are sinking into recession together. Forget claims that India has decoupled from the US and can keep growing fast regardless. India and most developing countries are indeed much less dependent on the US economy than in the past. So, Indian growth will be dented rather than smashed. GDP growth will slide from 9 % last year to 7% this financial year, and to maybe 6% next year.

Now, 7% is a miracle growth rate by historical standards. You might think that declining from super-miraculous to merely miraculous growth cannot be particularly painful. You would be dead wrong. The direction of change matters more than the absolute level. Rising from 5% to 7% is blissful, but falling from 9% to 7% is painful. And a subsequent tumble to 6% will be more painful still.

To appreciate why the direction of change matters so much, recall the 1990s. India went bust in 1991, reformed by globalising, and reaped the reward of fast growth. GDP growth averaged 7.5% in the three-year period 1994-97. India's growing integration with the world economy enabled it to share in the global economic boom of those years. Foreign institutional investors flooded into all emerging markets, including India, sending stock market prices spiralling.

Indian optimists thought that miraculous growth was here to stay. But along came the Asian financial crisis in 1997, and the Indian economy slumped along with the global economy. Indian GDP growth averaged just 5.5% in the next five years.

Now, 5.5 % may not sound too bad, just a modest deceleration from the 7.5% of the preceding boom. Indeed, India's 5.5% at the time was one of the fastest growth rates in the world. Yet, the change in direction, from acceleration to deceleration, caused enormous pain.

Industrial growth crashed in 1997-98, and barely limped forward for years. Many industries had borrowed massively during the mid-1990s boom to invest in world-class new plants, for which there was suddenly no demand. Huge projects were abandoned unfinished, with companies defaulting on mega loans.

These financial defaults brought the lending institutions also to the verge of bankruptcy, from which they were saved mainly by creative accounting and a friendly RBI. Medium and small companies crashed along with their larger brethren. Employment went into a tailspin. Stock markets crashed and companies stopped repaying fixed deposits, so household investors suffered trauma.

The budgets of the central and state governments assumed steady growth of revenue year after year. But the 1997 slowdown hit tax collections. Meanwhile, a bumper Pay Commission award hugely inflated the wage bills of central and state governments. So, governments, corporations, employees and household investors were all sucked downward into a whirlpool of distress. The only saving grace was the IT boom, sparked by the global Y2K scare. But that turned out to be a bubble, and it burst in 2001.

Difficult though these years were, they did not witness economic collapse. India did not revert to the old Hindu rate of growth of 3.5%, witnessed in the three decades after independence. GDP growth in 1997-2002 averaged a solid 5.5%. But the direction of change was downward, not upward, and that was enough to cause widespread distress.

I fear we are about to see a repetition of that process. As in the 1990s, a booming world economy first lifted Indian growth (and stock markets) to new heights for several years, giving rise to the illusion of permanency. As in the 1990s, the subsequent global slump is going to cause an Indian slump too. As in the 1990s, the fiscal problems of the government are going to be exacerbated by a Pay Commission award.

However, we are much better prepared for this downturn than we were in the 1990s. Our foreign exchange reserves are almost $300 billion, cushioning our balance of payments. Corporations have not gone on a borrowing spree paying 20% interest, as they did in the 1990s - they have large cash reserves, modest debt-equity ratios, and interest rates are much lower today. The banking system is in relatively good shape. The latest Pay Commission award this time is less onerous than the 1997 one. Our savings rate has crossed 30%, and can keep financing a healthy rate of investment. Infrastructural sectors like telecom, power, roads, and ports will be only minimally affected by a recession.

Nevertheless, pain will be widespread and sometimes deep. Income and job opportunities will slacken, sometimes dramatically. Many companies will suffer shrinkage or bankruptcy, especially small ones. Boom sectors like transport, restaurants, trade, real estate and exports will go into reverse gear. Credit will tighten, for consumers as well as companies. Corporate profits will slump. The revenues of central and state governments will fall, curbing their ability to alleviate distress. The stock markets will fall further, and the Sensex may fall below 10,000. Tighten your seat belts: we are running into rough weather

 

http://economictimes.indiatimes.com/Impact_of_global_slowdown_on_Indian_economy/articleshow/3577401.cms

Sharekhan Post-Market Report dated October 08, 2008

 

Sharekhan's daily newsletter   October 08, 2008   Index Performance Index Sensex Nifty Open 11,316.24 3,604.40 High 11,405.73 3,604.40 Low 10,740.76 3,329.45 Today's Cls 11,328.36 3,513.65 Prev Cls 11,695.24 3,606.60 Change -366.88 -92.95 % Change -3.14 -2.58   Market Indicators Top Movers (Group A) Company Price  (Rs) % chg Gainers Edelweiss Capital 400.85 9.91 Ranbaxy 279.25 9.08 Godrej Industries 104.70 5.02 Tata Power 804.60 4.79 NALCO 374.40 4.22 Losers United Spirits 939.30 -17.52 Aban Offshore 1,082.00 -17.49 Gujarat NRE Coke 38.70 -16.77 Bajaj Holdings 349.80 -16.50 Spice Tele 37.95 -15.76 Market Statistics - BSE NSE Advances 441 152 Declines 2,165 1,360 Unchanged 46 10 Volume(Nos) 32.42cr 61.51cr  Market Commentary  Late buying trims losses A late round of buying helped the market pare most of the losses and Sensex shed 367 points at the close. The Sensex bucked the major downtrend across the Asian markets and trimmed 580 points of losses on late buying in heavyweights. The market was once again hit     by a substantial selling pressure and both Sensex and Nifty tumbled by above 8% amid a choppy trading session. Taking cue from weak global markets, Sensex opened on a negative note at 11,316 and fell sharply to touch an intra-day low of 10,741. While the market witnessed a fluctuating trend for a while, the afternoon trades saw sudden buying interest in frontline stocks and Sensex chopped off most of its losses to close at 11,328, down 367 points or 3.14%. Nifty, too, bounced back sharply and closed at 3,514, down 93 points. The market breadth was negative. Of the 2,652 stocks traded on the BSE, 2,165 stocks declined whereas only 441 stocks advanced. Fourty six stocks ended unchanged. All the 13 sectoral indices were largely weak. The BSE CD index lost 6.75%, BSE FMCG index declined by 5.18% and BSE IT shed 4.90%. The remaining indices lost 1-4%. Among the 30 Sensex stocks, 24 ended in the red. Among the major losers JP Associates tanked by 9.91% at Rs90.95, Wipro tumbled by 7.91% at Rs282.35, Sterlite Industries declined by 6.85% at Rs292.55, ICICI Bank plunged by 6.53% at Rs453.50, State Bank of India dropped 6.10% at Rs1322.15, Tata Steel crumbled by 5.36% at Rs338.20, Satyam Computer  Services slumped 5.14% at Rs264.70, ITC fell by 5.13% at Rs165.60 and Tata Consultancy Services declined by 5.07% at Rs546.60. However, Ranbaxy Laboratories advanced 9.08% at Rs279.25, Tata Power jumped 4.79% at Rs804.60, Mahindra & Mahindra surged 2.75% at Rs486 and DLF gained 1.95% at Rs308.80, while Reliance Communications closed with marginal gains. Over 2.23 crore JP Associates shares changed hands on the BSE followed by Reliance Natural Resources (1.25 crore shares), GVK Power and Infrastructure (1.22 crore shares), Chambal Fertilizers & Chemicals (0.78 crore shares) and IFCI (0.70 crore shares). Reliance Industries was the most actively traded counter on the BSE and registered a turnover of Rs434 crore followed by Reliance Capital (Rs287 crore), ICICI Bank (Rs251 crore), JP Associates (Rs209 crore) and the State Bank of India (Rs152 crore). European Indices at 17:20 IST on 08-10-2008 Index Level Change (pts) Change (%) FTSE 100 Index 4607.92 2.70 0.06 CAC 40 Index 3708.47 -23.75 -0.64 DAX Index 5254.12 -72.51 -1.36 Asian Indices at close on 08-10-2008 Index Level Change (pts) Change (%) Nikkei 225 9203.32 -952.58 -9.38 Hang Seng Index 15431.73 -1372.03 -8.17 Kospi Index 1286.69 -79.41 -5.81 Straits Times Index 2033.61 -143.94 -6.61 Jakarta Composite Index 1451.66 -168.05 -10.38

 

 

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Road map for derivatives & bond mkt soon

The government is likely to go ahead with its road map for developing
the bond, currency and derivative markets, although experts such as
former RBI governor C Rangarajan have said it could review the road
map for new products in the light of developments in the US.

The finance ministry believes the Indian financial sector regulators
have been more circumspect than western regulators and, therefore, the
market could be opened further. Notwithstanding the role that
investment vehicles like credit derivatives played in the collapse of
investment banks in the US, the government believes it should try to
bring a substantial part of the global financial services industry to
India's financial capital Mumbai.

Government sources said the country should capitalise on the current
weakness in the western financial services sector to develop the
financial services industry in the country. At present, many corporate
houses go to offshore financial service hubs such as Singapore to meet
their financial services requirements.

Hence, exchange-traded derivatives such as interest rate futures and
credit derivatives are likely to hit the local market soon. Government
sources said that exchange-traded interest rate futures would be
introduced by February 2009.

The finance ministry is now closely observing how the recently-
launched exchange traded currency futures market is working. It is of
the view that the spread in these contracts is declining, which
indicates increasing liquidity — a good sign. It will observe the
performance of the market for some time before finalising the norms
for other products, it is understood.

The ministry would also consider liberalising the currency futures
markets by allowing NRIs and FIIs to invest in these after studying
the performance of the market. The finance ministry's idea is to
create a financial services market that is missing as of now in the
country.

While big corporate houses can shop abroad for the sophisticated
products they need to hedge currency and other risks, small and medium-
sized companies, which compete with imported products here — price of
imported rival products is also a function of exchange rate
fluctuations — are not able to hedge their economic exposure to
exchange rate fluctuations.