18 November, 2008
THE GLOBAL FINANCIAL CRISIS: an overview
PART II: The Bubble bursts!
By: Dinesh Gopalan
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 Smithwho got the NINJA loan,realizes that he cannot affordto
make the repayment. He goes to the bank, returns the key to Uncle Bankerand 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 paymenton the
loan. An additional incentive to borrowing for owning a house, and negotiating very long
John Smith’s loan is foreclosed and his house put up for sale. Several such houses started
entering the marketin 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 oftheir house drop significantly below what they had
signed up to pay as mortgagepayments 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 repentfor their generously avuncular lending
practices; therewould have beena 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 impacton
the overall economy. People would have concluded that those who did not know what they
were doing and lent to NINJAs hadit 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 alot 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 placewith the housing loans as thebase had spread so much
within the system that no one knew who held what. John Smithwalking out of his house in
Nebraska, resulted in several people losing half their retirementsavings, 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 merelywaiting 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
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 reflectthe 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 asituation
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 createand hype up? If you borrow up to 30 times your net
worth and invest it in a certain class ofasset, 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 timestheir net worth, and it
was all their creditors’ money. The so-called AAA companies to whompeople lent
without security, believing their moneyto be as secure as with the government,were
bankrupt, or nearly so. Bear Stearns was about to go under, when the Fed brokereda deal
with J P Morgan who bought it at fireside sale prices. This was in March 2008.
Banks and other institutions who lose moneyin 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 backedby 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 marketsbut in the international markets as well. The merchantbanks and other
institutions who owed them money in turn had to start selling their stock holdings both in
the domestic andinternational markets.
Stock prices started falling. This resulted in equity mutual funds seeing adrop in their
NAVs and hedgefunds 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 AIGin the meanwhile? They hadinsured 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 handedout. This resulted in actual
outflows due to payouts as well as freshcollateral requirements. One of the most solid and
respected insurance companies of the world wasin deep trouble. Insuring millions of
houses across the country against an earthquake is based on the premisethat when disaster
strikes, it does not strike the whole country at once. Insuring millions of CDO’sagainst
defaults is a bad idea, since when disaster does strike, they all go under atthe same time.
Lehman Brothers, another big ticket Wall Streetmerchant 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 succeededin selling themselves to
other institutions or have beentaken over by thegovernment. The justification offeredby
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 atseveral governments in the world.
The fall of Lehman did have huge consequences. Whoever had lent to Lehmanof 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 benchmarkslike the Dow. What people do not realize or probably ignore, in
the hoopla surrounding the marketing ofsuch 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 theissuer 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
Stock markets around the world haddropped significantly in September from their January
levels. The Sensex was around 14,000 afterreaching a high of 21,000 in January.
Investors who saw the Sensexrise from a level of 3000 in April 2003 to seven times that in
five years, suddenly saw a drop of 30 percent in afew months’ time. The fall in the Sensex
was attributable to growth projections moderating due to aslow 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 frameworkfollowed 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 fromwhat
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 borrowfrom other banks and
institutions more than a certain percentageof 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 LehmanBrothers filed under Chapter11, Merrill
Lynch was takenover by Bank of America. The Wall Streetfirm 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 farless
and be under greater regulatory scrutiny in return forgovernment assistance. Several icons
of Wall Street all fallen in asingle month; the casualty list was growing.
The government announced a bailout package for AIG, and took over the ownership.
Fannie Mae and FreddieMac 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
The US governmentannounced 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 alarge scale, being handed out to people who least
deserved it, in order to averta world economiccollapse. Central banks across the world
started cutting interest rates and announcing bailout packages forbanks in distress.
Panic set in across all markets. Banks were unwilling to lend to each other since they were
not sure whethertheir money would come back. Being insiders, they were also the people
who understood best that the whole industry was facing acrisis 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 wereseeing their
NAVs drop andredemption pressures rise. The Reserve Bank did all this as well. It also
announced relaxation of the curbs oninvestments of FII’s through Participatory Notes,thus
effectively doing away with know-your-customer norms. Desperate measuresall, 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 marketsused to recover
somewhat; only to sink again within hours on receipt ofanother set of bad news. The
period from September to now has seen extreme volatility in stock markets acrossthe
world. They have all sunk to recordmulti-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 fewmonths, 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 managerslike George Soros and
Philip Falcone who to the dislike of all made a lot of moneybetting on the marketsin 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 measuresto 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 afestering
wound and pretending that it would heal.
How is the commonman and the establishment reacting to this? The common man, poor
chap, is suffering fromacute 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 marketwhich had witnessed an unprecedented boom
for the last four or five years is melting. All growth projections for most industries across
the world havebeen revised severely downwards. India and China havealso seen
downward revisions of growth projections – GDP growth in India is expected to slow down
to 6% levels fromthe earlier projections of around 9%- which is still good news since
these two economies areat 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 Rupeedepreciating to Rs.50 to the dollar, from Rs. 39
levels a few months back. Companies in sectors depending on exports of goods and
services haveseen 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. Companiesin sectors which depend on leverage and
rising asset prices are in trouble. Real estate companies arein the doldrums and all set to
default on their loan obligations. Infrastructure andlogistics companies haveseen severe
correction in shareprices. Sectors that depend on generaleconomic activity being robust
have been affected.These include hotels, travel and entertainment industries. Though no
company or sector hasbeen spared the meltdown in shareprices, 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 coveragehas 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.
(The views expressed above arepersonal views.)