How the house came down

The force of a correction is equal and opposite to the deception that proceeded it. Never before in the history of the world have so many people believed so many things that couldn’t be true. Now, they owe more money to more people than ever before. And it could take a long, painful correction…or worse…to straighten things out.

Dailyreckoning.com

The daily reckoning is a website that isn’t exactly known for its cheery take on stock markets (another sample of doom from DR: Every market is a public spectacle…It begins with lies and humbug…And finally it ends in disaster).

But then again last fortnight’s long-drawn-out carnage across global markets would have been adequate to shackle even the most optimistic bull on any bourse, right from Wall Street to Dalal Street. When the US Federal Reserve eventually stepped in—after markets across the globe had tumbled by between 5.5 and 16 per cent—with a cut in its primary discount rate in a bid to calm nervous investors, sanity began to creep in almost immediately.

The Dow and the NASDAQ bounced back smartly, and the UK’s FTSE 100, France’s CAC and Germany’s DAX began to turn around. At the time of writing, most Asian markets had shut before the US Fed’s half point cut in its lending rate to banks—and had predictably ended in the red. But news of the Fed’s attempt to calm markets appeared to have gone down well with investors back home, pointing to perhaps a fresh bout of robust buying in the following week.

Says Amitabh Chakraborty, President (Equity), Religare Securities: “The bounce back in the US will see our markets recover, but this recovery will be short-lived with uncertainty still prevailing over US subprime.”

The multi-billion dollar question, however, persists: Is the Fed’s reaction enough to banish the bears once and for all, or does—in DRspeak—“ the long, painful correction” still have to run a fair distance before it peters out? And if indices are still some way from finding a bottom, does that mean flows from foreign institutional investors (FIIs) — on which Indian markets are heavily dependent — will ebb?

After all, the FIIs had pulled out nearly $1.6 billion (Rs 6,560 crore) from domestic equities between July 26 and August 16. On the day the benchmark Sensex crashed by 642.70 points—on August 16— the foreign bandwagon had pulled out all of $705 million (Rs 2,890.5 crore) from Indian stocks. Between end-July and the second week of August, FII flows out of Asian markets like India, Indonesia, Taiwan, Korea, Thailand had topped $8.5 billion (Rs 34,850 crore).

The genesis of the global rumble of course lies in the US housing market where, after years of a noholds-barred boom, lenders to borrowers with a poor credit profile finally ran out of steam as delinquencies and defaults mounted.

Billions of dollars of these subprime loans had been bundled into securities on Wall Street, and investors like hedge funds and pension funds were big buyers, pursuing yields as high as 20 per cent. But as the subprime market bombed, those securities lost their value, triggering off a liquidity crisis of gargantuan proportions.

The US subprime market is larger than the Indian economy. According to Mortgage Bankers Association in the US, as on March 2007, the subprime market was 13 per cent or $1.27 trillion (Rs 52,07,000 crore) of the total $9.8 trillion (Rs 401.8 lakh crore) size of the US outstanding residential mortgage debt market. Some 13.3 per cent of those in the subprime market are expected to be defaulters. Nearly $170 billion (Rs 6,97,000 crore) is estimated to be at stake. According to Bloomberg, Calyon, the French investment banking unit of Credit Agricole, has estimated a loss of $150 billion (Rs 6,15,000 crore) because of the subprime problem.

Even as the US Fed and the European Central Bank rushed in to pour money into an arid financial system, banks—the packagers of the mortgage securities—began to reel. Bear Stearns, the fifthlargest investment bank in the US, stopped investors from redeeming money from two of its hedge funds. A steady stream of other funds and mortgage lenders followed suit and stopped redemptions.

Says Gurunath Mudlapur, Managing Director, Atherstone Institute of Research: “With one announcing his problem, others also took the opportunity to disclose their wounds. It is clearly evident that the problem is not small, otherwise banks wouldn’t have come out openly as they have a reputation to protect.”

The malady quickly spread across continents. Union Investment, Germany’s third-biggest mutual fund manager, also stopped redemptions from one of its funds after investors pulled out about 10 per cent of its assets. The Netherlands-based BNP Paribas suspended redemptions from three investment funds worth m2 billion (Rs 11,000 crore), citing problems in the US subprime mortgage sector.

On the same day, Dutch investment bank NIBC Holding NV announced losses of $188.6 million (Rs 773.26 crore) from asset-backed securities in the first half of 2007. The liquidity crunch resulted in central banks in the US, Europe, Japan, Australia and Canada adding about $132.7 billion (Rs 5,44,070 crore) to the banking system in an attempt to avert a crisis of confidence in global credit markets. Says Sameer Koticha, Director, ASK Group: “The immediate infusion will bring in stability on the liquidity front and will help improve sentiments.

However, for long-term benefits, it would require structural changes to be undertaken by the Fed like a softer fiscal policy in a controlled inflationary environment.” The Fed did indeed respond with a lending rate cut. But is that good enough to tide over the crisis? Says Andrew Holland, Head (Strategic Risk Group), DSP Merrill Lynch: “It (the crisis) has moved beyond subprime woes. The whole credit market is struggling. No one knows the extent of the problem and, therefore, investors across the globe have been taking off money across asset classes.” Adds Alok Vajpeyi, Vice Chairman & Managing Director, Dawnay Day AV Financial Services: “It is no more a crisis of only subprime woes.

There are concerns over defaults by real estate borrowers and their impact on the pure debt market and the US economy.” If investors have been running scared, it’s because nobody’s quite sure about the size of the black hole out there. “Markets don’t like uncertainty and till the puzzle as to who owns all the garbage of securitized debt led by subprime loans is not known, selling from FIIs will continue,” warns Rushabh Sheth, Managing Director, Karma Capital, an advisor to FIIs and hedge funds.

“The problem is not what we see happening but what we don’t see. We don’t know the price of these assets. We don’t know which banks are exposed to this sector,” adds Sheth. And as Mudlapur puts it: “Everyone is playing blind. No one knows what is in store.” The US Fed’s attempt to calm investors may work in the short term, but the bears might well be still on the prowl.