Science of Financial Markets- Can it explain the current Credit Crisis ?
I am suddenly nostalgic being in Asset Management class at Warwick Business School…I remembered my science classes in school.. In 10th grade we learned about the Big Bang Theory and the concept of black holes, white dwarf, etc.
These concepts I guess I can relate to what is happening now in financial markets. A Big Bang has taken place. And the financial markets are shrinking rapidly and are pulled towards their origin by the strong forces of greed, contamination and deregulation. This will result in creation of black holes. In this black holes, the gravity of these forces will be so strong that not a single ray of light can pass through it. I am not exaggerating the magnitude of financial crisis, I am trying to show its impact. Its more than just a financial crisis.
Probably not many people will believe that few people in the industry had predicted this Sub-Prime crisis as early as 2005-2006. Warren Buffet and other notable experts in the filed have recorded their statements that USD will depreciate in future and is in a long term depreciation trend. To add to this, I had presented a similar report in my college in 2005 on the same issue of Sub Prime crisis and tried to evaluate the housing market in USA and tried to identify the asset bubble in making,. In addition, I extended my framework to include gold as an asset class rather than an commodity and pointed out the possible scenarios where gold would outperform the other asset classes. In my report, I clearly mentioned that the spectacular credit growth which led to inflationary asset prices could not be sustained in future and would lead to creation of circumstances which will lead USA and the world economy into a vicious cycle of recession. It would lead to a combination of depreciating dollar, rising interest rates, high unemployment rates, defaults in housing market. And now, the results are in front of us.
Rationale:-Behind Crisis
The reason is very clear whenever anything rises at alarming levels it has to come down at similar periods. Again, I would like to relate this to Newton ‘s Gravity Theory. Issac Newton discovered the Gravitational Theory and concluded that any thing that goes up has to come down back to earth and the speed at which it comes down is faster than it goes up. So please remember these theories and concepts, it has indirect applications in finance. So if you scored well in science, you would score good in finance. In past four years, stock markets experienced spectacular Bull Run and the equities zoomed as if USA & Russia were releasing rockets from earth. But every bull run teaches its own lesson. In 1990’s after the dot com bubble, people became wary of high P/E multiples as high as 100-400 times which were allocated to dot com companies. In fact, for some time when the returns were generated and people who bought these stocks at 100 P/E ratio were able to see it to another fool for 300 P/E ratio, even investor like Warren Buffet was astonished and made public statement that for the first time his research was wrong and probably market was right in its judgement. Soon after he made his confession, in few months the dot come bubble took place and stocks went crashing. After 2008 crisis, people in future will understand the importance of identifying risk involved in asset, its payoff and associated cash flows.
Had government exercised effective regulation and control on the financial system and imposed stringent capital adequacy norms, the present situation would not have arose. Hedge Funds in US were completely unregulated and there was no check on their activities such as speculation, high leveraging etc. In fact, hedge funds used to go to havens like Bermuda, Mauritius etc to escape from regulation. In past decade, the financial markets made easy for I-Bankers, Hedge Fund managers to earn quick buck. Most of the analyst were new and just experienced the bull run and had never experienced bear run. Thus any stock selected by them performed well in the bull run because of systematic return ie correlation with the index. So they never actually knew how to pick growth and quality stocks, nor could they read off balance sheet items and secret reserves build by the company. People like Warren Buffet understood financial statements and made money. To add to this, when Warren Buffet was asked what do you think your successor should be good at ? He said that my successor needs to be able to analyze the financial statements and especially the off balance sheet items.
Another reason is the unaccounted investments of Hedge Funds. This are specialized institutions that are willing to take risk and beat the market and generate excess return on investments and are looking to make a quick buck in short time. South East Asian Crisis is an example of how can these short term foreign inflows and outflows can distort the BOP of an economy. These funds invest money in un chartered territories and seek advantage of being first mover. Due to their high bulky investments, they attract market attention to that particular asset class. For instance, since 2005 the money flowed into the Equities, mortgage backed securities and other riskier assets. The result bull run in equities. Retail investors entered at peak and are in losses, while hedge funds exited at profits at peak. Then this money made way into commodities like Crude, Base metals, precious metals, agricultural commodities etc. And suddenly the commodities started experiencing a bull run. Crude rose from $70 per barrel and reached sub $150 levels in a short period of time. There were no fundamental reason that justified the magnitude of rise in such a short period of time. And as expected when on corrections, hedge funds were exiting and booking profits, retail investors entered and booked looses. Now the money has flown out of crude and will look at gold as its safe heaven. Gold., as in investment class will be looked upon by investors in next 2-5 years to beat inflation and for safety of capital. One of the reason for the large size of hedge funds was the sheer number of funds launched in short period of time. In Wall Street, any I-Banker with an Ivy League MBA could launch his hedge fund and within hours he would get several billions to start his fund. This unregulated industry presented data of its best fund to raise capital and the funds which failed were not reported at all and thus returns which were reported were biased and misled investors.
Another important reason for the crisis has been structured derivative products and its complexity. The main aim of the derivatives was to enable asset holder to hedge his risk. But the doctorates in physics, math, statistics and ones from engineering background created complex derivatives products whose pay off were not easily determinable and hence the clients-corporates could never understand the risk associated with the product and its pay off. Thus when markets reversed, as in case of Indian IT industry, on one hand they had windfall gain due to depreciation of ruppe on other hand losses from hedges. These left their balance sheet red. The creators of structured products themselves never understood the product and its implications and hence could not analyze the product because they lack the knowledge of financial concepts etc.
Impact of Credit Crisis
The impact of crisis can be measured from the following facts: Fed Reserve has injected 700 billion USD into the system, BoE has injected more than 400 Billion GBP into the system. Bear Stearns and Lehman Brothers have been bankrupt, AIG suffered huge losses and Fed Reserve had to intervene to protect counterparties which were predominantly pension funds, retirement funds etc. Iceland ‘s banking system has collapsed. Russia is seating on around 250 billion USD and is bailing out Iceland, but guess that wont be enough and Iceland is very angry as none of the Western Counterparts are willing to help. The reason is evident, Fed would handle its own economy or Iceland? ECB has asked its member nations to develop their own plans to bail out their domestic banks and central banks throughout the world have coordinated their monetary policy to ease the tight liquidity position in the money markets. The money markets have literally frozen. With LIBOR rising as high as 5%. Nobody is willing to lend in the money markets and after 2001 for the first time there have been such heavy withdrawals from money markets. The banks are trying to recapitalize themselves and holding every penny of money. This has adversely affected the expansion plans of quality corporates because the debt markets have literally frozen. Banks firstly don’t have enough money to lend and secondly they perceive the credit risk is too high.
Will Bail outs be effective? I doubt
I would like to point out that the bail out plans of Fed Reserve and BoE will not necessarily solve this issue. Market will take its own time to assess risk and adjust accordingly. In many of these financially important centers, the size of the banking system exceeds more than 5 times the size of the economy. Take for instance UK, the size of the banking industry is more than 5 times the size of the GDP. This means recapitalizing banking system by 1% requires 5% of GDP borrowing. Thus even a small 5% recapitalization plans would require more than 25% of GDP borrowing and that would take already high levels of Fiscal deficit to still higher levels leading to higher inflation and higher unemployment rates. So here one can see how much dependable these bail outs are. Moreover, higher levels of fiscal deficits would still requite high levels of taxes, which is not possible because slowing economy would reduce incomes and hence the tax collections. The more interesting part is to see how does government handle the defaults in newly nationalized banks like RBS. Will government exercise its right on the collateral to recover loans and ignore that it is responsible for the plight of its citizens.
The current situation relates to Liquidity trap as described in the Keynesian Economics. Eventually, the rate of interest will fall so low that this will lead to an infinite demand for money. As it has been in Japan, where the real rate of interest has been negative for more than a decade and property prices are at 40% of their peak in 1990’s. Until, the credit markets are not stabilized and the confidence levels are restored in the credit holders I don’t see any ray of light in the black hole. For the first time, have investors learned their lessons by not caring out proper risk identification. In last crash in 1987, only the equity holders lost money but the debt holders didn’t even when the bankruptcy was declared. So these were considered to be safe, for the first time has the write downs have been to such a large extent that they have completely wiped off bank’s balance sheets and curtailed their ability to raise capital. This has lead to default and for the first time will the credit holders will suffer losses on a wide scale. A research has even pointed out that sovereign bonds which are said to be risk free are essentially not risk free and more than 27 sovereign bonds have defaulted. Moreover, these carry interest rate risk, purchasing power risk, exchange rate risk for international investors etc. So essentially the concept of risk free rate does not hold true. And investors need to price in the extra risk premium. This will lead to re allocation of wealth among various asset classes. The rate of return required from a bond as compared to earlier (ceteris paribus) would rise significantly and this would have deep impact on the bottom line of highly leveraged companies and would render most of their projects unprofitable and may even force them to delay projects due to non availability of cheap and required capital. Thus only companies which have adequate capital to fund their expansion plans and have strong operating cash flows would survive. That’s why adage goes’ A money today is better than money tomorrow’ and every business should have enough cash to take advantage of market imperfections and opportunities.
Central Banks are cutting Discount rate steeply because they want to improve the liquidity in the system and ensure that there is enough capital in the system but it fails to realize that this money is just finding its way into the treasuries of banks and in reality wont be made available for lending. In fact, one school of thought believes that the rate interest should rise sufficiently to compensate the investors of credit and interest rate as well as purchasing power risk. Only when the rate rises significantly, will investors opportunity cost of money will rise and they part away with money. The speculative demand for money will reduce and money will be deposited with banks and made available for lending. The reason being that the demand for speculative money reduces as the rate of interest rises.
Paradigm Shift-From deregulation to nationalization
Few months back, inflation and rising crude prices was a big concern and suddenly the focus has shifted to more important events like nationalization of banks in UK, USA etc. See the irony, few months back developed economies like USA, UK, EU were advocating liberalization of financial services industry, free movement of capital, deregulation of financial services industry, denationalization of banks and privatization bla-bla . What has happened now? The same nations are now harping the tune of nationalizing banks and using tax payer’s fund to recapitalize national banks and save their banking system from collapsing. Few months back, London and New York were the teller counters of this world economy and whoever wanted money went to these counters and raised money; whatever may be the need speculative demand or investment or consumption demand.
Emergence of ASIA-Middle East
I think soon the Economic power will shift to Asia (including Japan) and Middle East Region specifically. I would like to be say that in future I see Dubai, Egypt, Hong Kong, Singapore and Mumbai as the upcoming international financial centers. And among these specially Dubai, Singapore and Hong Kong. The cash rich OPEC countries are spending heavily on tourism and infrastructure. UAE has completely transformed itself in last decade, and is making most of its windfall gains from high crude prices. It is targeting itself to be one of the most sought after tourist destinations in the world. Most of the I-Banks and other industries are increasing concentrating on Dubai as its base to cater to the Middle East countries. They are hiring in a big way in Middle East and soon the senior management would handle the company affairs from Middle East base.
I think investing in Indian Stock markets are better than its Asian peers. I know, many of you may say I am wrong and China is the place. Please bear and give me a chance to justify my answer. China like other Asian economies viz Singapore, Malaysia etc is export oriented economy. India on other hand is a domestic consumption driven economy. It still has high Balance of Payments deficit, reason it imports crude in high volumes. And in addition, its exports don’t match its imports. Off late, the deficit in current account has been matched with surplus in the capital account, thanks to the FII and booming stock markets. But again, with FII withdrawing money, rupee has depreciated vis-à-vis dollar and foreign kitty has been reduced. But still, I feel rupee is in a long term appreciation trend and once the unwinding in the credit markets is done with, dollar will depreciate further. What makes India an attractive destination to me is its young population. It has a high proportion of its population who are in their middle ages and are spending high proportion of their income on luxuries and other consumer durables, making India less affected by slowing demand from export markets. The other thing, which has recently turned into India’s favour is 123 agreement. Since long, the shortage of energy has withheld the development of rural areas and there are power cuts in many parts of India and many areas have no access to electricity. Nuclear energy is a clean and green energy and will reduce India’s dependence on crude to some extent and make the demand for crude from inelastic to elastic in long run. Though the advantages of this deal will take 3-4 years to start accruing but it’s a positive step and this is Manmohan Singh’s greatest achievement I guess. He took a tough decision and even risked his Chair. He will be remembered as a man who single handedly turned Indian Economy, which was in a terrible state in 1991 to India which is looked upon by world as the fuel for the growth of world economy. Economics always says that the impact of policy decisions will accrue in the long run. His financial sector reforms in 1991 set the stage for growth in 2000’s and now 123 agreement will provide new impetus to growth in India.
Sir. Warren Buffet & Mr.Rakesh Jhunjhunwalaji- Stock Market Barrons
Billionaires like Warren Buffet and Mr.Rakesh Jhunjhunwalaji can easily read singals of market and can withstand the turmoil in the markets and probably that is the reason they have been able to earn massive wealth from stock markets. There is a common principle these investors follow: When markets rise, we should see and when markets are selling we should buy. These investors buy at troughs or just before recovery starts and sell when the markets are at peak and the valuations are expensive and defy fundamentals. One more common principle they employ is : due diligence of the target company. One of the reasons why the crisis took place was that, bankers were busy minting money for themselves. They were ambitious and wanted to meet their targets and were happy with their fat salary and bonus cheques. I-Banks have virtually vanished and are aliens and perhaps future generations wont even know that in past there were financial organizations such as I-Banks. In greed of money, the young analyst compromised with the due diligence process, they did not study the target company product, management quality, competitive position, economy’s trend, production process etc in detail. Crunching numbers, does not mean you have made a good investment. What differentiates Sir. Warren Buffet and Rakesh Sir is their ability to perform a top-down analysis of the target company and integrating it in a broader landscape with the domestic and global economy. They choose companies which are close to natural monopoly and this gives these companies pricing power, certainty in cash flows, uninterrupted demand etc. Readers don’t even think for a moment, that there are no monopolies and they are not investing in current periods and are just reaping from past investments. Sir Warren invested in a transportation company which had 80% -90% on its route in USA, he invested in a candies and chocolate manufacturing company. Sir Rakesh invested in Crisil, which had a near monopoly in India when he invested and negotiated with S&P when it bought Crisil. They invest in companies which they believe have long term fundamentals and not on basis of short term price targets, M&A, etc. They buy stake in companies in which they think even if they have to buy 100% equity of that company from market, they wont be in loss because they are sure that the company would earn enough profits to make their investment profitable. Another factor which distinguishes them from other is their size of investment, which gives them the negotiation power. Rakesh Sir negotiated in a big way when they sold Crisil’s stake to S&P and helped other share holders in realizing fair return on their investments. The reason why companies like Goldman Sachs, S&P agree to their terms is because the kind of experience and value they add to the company. They can turnaround a company in short period of time and work closely with the management to improve the growth of the firm.
And if u trust my instinct and as far as I know them, both of these genius are on a shopping spree now. They were seating on huge cash balances waiting for right time to deploy funds and will now start bottom fishing in few months. Who knows, they might already have begun talks with managements as well. And Sir Warren has already bought stake in the Wall Street’s sought after firm Goldman Sachs. Infact, I would recommend investors with long term horizon to hold on cash and start deploying funds in fundamentally sound companies with good track record of management, earnings visibility, strong cash flows, low leverage, adequate capital to meet capex requirements for next 2-3 years. Wont advise any particular sector but few companies which meet above said criteria.
From
Pratik Tibrewala
Msc Finance WBS