Near-term prospects for financial
markets are weak and we need to adapt to that prospect
Last month we had discussed how the difficulties in
pinning down the actual size and location of sub-prime related losses, due =
to
the mutually reinforcing and escalating actions of loan delinquency, falling
property prices and mark-to-market rules, have led to the current vacuum in
confidence. Financial institutions were hoarding their cash and as a result=
the
normal transaction process had begun to stall. The gathering uncertainties =
were
creating conditions extremely inimical to the prospects of a recovery in
confidence and hence by extension of the global economy. Things have just g=
ot
worse. The most direct and heavy burden of this negative development on the
Indian economy will be by way of sharply constraining the capital raising
capacity of Indian companies.
Over the weekend of 12–14 September, the cri=
sis came
to a head. The US financial regulators let Lehman go, saw Merrill packed in=
to
Bank of America and agreed to provide a credit line of up to $85 billion fo=
r up
to 24 month at 850 basis points above 3-month Libor to AIG, the insurance g=
iant.
The US Fed statement says that the “U.S. government will receive a 79=
.9
percent equity interest in AIG”, but the exact nature of this, whether
through issue of conditional warrants or straight equity is yet not clear. =
The
collapse of Lehman and doubts about the AIG credit line going through sent
asset markets plunging as investors lunged to cash. On Wednesday 17 Septemb=
er 2008,
the yield on 3-month Treasury Bills fell to 3 (three only) basis points (bp=
s),
i.e. 0.03%, the lowest in more than half a century.
Over the last weekend the US government announced a
second version of the Resolution Trust Corporation originally launched in t=
he
1980s to clean-up the Savings & Loans (S&L) mess which was also a
mortgage crisis. The proposed $700 billion fund needed legislative approval
from the US Congress and with time ticking away the markets were first edgy=
and
then downright nervous.
The total of securities issued on the back of subp=
rime
and Alt-A home loans are estimated to be $2.1 trillion, while some 7 million
subprime and over 3.6 million Alt-A loans exist totalling about $2.5 trilli=
on. It
appears that the $700 billion Paulson Fund is additive with the $314 billio=
n of
commitments made by the US Treasury and Federal Reserve till date, thus mak=
ing for
a total commitment of over $1 trillion. American and other banks and financ=
ial
institutions have to date taken some $400 billion in write-downs and some t=
roubled
assets have accompanied Lehman to bankruptcy court. All of the loans underl=
ying
the $2.1 trillion of mortgages cannot go bust and it is hard to see how a
cushion well in excess of $1 trillion cannot but substantially ease the pai=
n.
The problem that has seized the market is that of
complete uncertainty, a loss of confidence in their counterparties –
conditions under which a financial market cannot but grind to a halt. While
markets have been nursing fears about whether US Congress would pass the
Paulson bill, commentators have been cramming the sidewalk denouncing the p=
lan
and hawking their alternative schemes. Legislators are genuinely apprehensi=
ve
of signing on. However, it would be hard to imagine anyone willing to take =
the
responsibility for a collapse of the financial world on their own heads, and
thus there will be an element of duress when the bill eventually passes, and
that it will.
Many centuries ago Thomas Gresham pointed out that=
bad
money drives out the good. The subprime based CDO market and its many creat=
ive
offshoots have in a sense created bad money that is pushing out the good. T=
he $2
trillion of suspect securities have created havoc for a US credit market of=
$50
trillion and an equity market of $20 trillion, as well as for the rest of t=
he
world. The obvious recourse is to lock up the bad money by sequestering it =
–
and that is what the Paulson plan is essentially about. Perhaps it could ha=
ve
been improved upon, perhaps it should have been rolled out earlier. There w=
ill
be many fully justified critiques of the regulatory mishandling of the cris=
is,
but right now the bad money has to be locked up.
If it happens it will certainly ease the immediate
travails of the marketplace. But plenty of cleaning up will be needed. For =
one
thing it is not clear whether the Fund will act as an extended repurchase
facility (i.e. a pawnshop) or will buy the distressed securities outright. =
If
it is the latter there will be hurdles to be crossed in what will be the me=
thod
of pricing and if there will be accompanying covenants on loss-sharing. The
Credit Default Swap (CDS) market has apparently grown to $53 trillion about
which Mr. Cox, SEC Chairman, said there is no regulator, by which he probab=
ly
meant that nobody has a clue about it. The financial industry believes that
most CDS can be netted out and the problem is tractable. If so, this ought =
to
be carried through over the next few months, and with some urgency, for qui=
te a
bit of CDS are attached to subprime constructs and these tentacles reach far
and wide.
The US government will have to pick up quite a bit=
of
additional debt, even if some of it can be paid down later as the securities
market recover. That is likely to push inflation and interest rate prospects
higher and the dollar down. The latter may be offset by the fact that the
Euro-zone is facing an economic downturn and some return to financial norma=
lcy
may see greater interest in the dollar. Many investors will try to hedge
against higher inflation and weak currencies by moving into commodities =
211;
oil, gold and the like – and that may further stimulate inflationary
tendencies.
Most pertinently, Indian companies will find the g=
oing
rough to raise capital in international debt and equity markets. Government=
can
help by dispensing fully with the temporary restrictions on ECBs introduced=
on 7
August 2007. It should raise the cap on FII investment in debt substantially
and in general ease the inward flow of foreign capital. That will help
stabilise the currency and make it eventually easier to raise overseas fina=
nce (and
refinance existing loans) for the ongoing expansion in fixed creation in
manufacturing and infrastructure. It will be perverse to persist with flood
control mandates in a drought.
(The author is Economic Advisor, ICRA)
[Total number of words excluding title: 1,062]
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Saumitra Chaudhuri &=
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Economic Advisor
ICRA Limited &nbs=
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26 K G Marg,