The Unwinding Begins

A discreet way of referring to the death of an individual is to call

it a "milestone event". The year 2008 has seen milestone events for

some of the world's largest financial institutions. Bear Sterns was

swallowed by JP Morgan, Fannie Mae and Freddie Mac were nationalised,

Lehman Brothers is bankrupt, and Merrill Lynch sold itself to Bank of

America. The last four events happened in successive weekends.

Individually, they would be earth-shaking; tog-ether, they tell us the

ground is shifting, which may mean more aftershocks will follow.

In the two days after Lehman, the Nifty fell over 7 per cent. Is this

a knee-jerk reaction to events halfway around the globe, or will we be

affected in a lasting manner? I think it is the latter.

Between 2003 and 2007, India got unprecedented foreign funds—foreign

direct investment, purchases of equity (FII), foreign borrowings by

Indian corporates (ECBs) and NRIs sending money home. This supplied a

lot of investible cash, which lowered interest rates. This made it

easier for entrepreneurs to expand capacity, and cheaper for consumers

to buy cars and homes with borrowed funds. All this money drove up

share prices, which seemed justified by the visible economic growth.

Now, money is retreating all over the globe, and the Indian rupee is

dropping fast. How did this happen?

Money gets created when banks lend money. Tradi-tionally, on a deposit

of Rs 1,000, the bank would lend Rs 900, keeping a safety margin of 10

per cent for withdrawals. If the borrower spent the money on a shirt,

and the manufacturer banked it, his bank could lend 90 per cent of

that: Rs 810. And so on.

Over the last decade, money got created by der-ivatives. One example

is mortgage-backed security (MBS). Here, a home loan became the

buyer's liability, and the bank's asset. The bank resold a package of

such loan assets to another bank, while a third-party assessed the

risk of default of these loans. If the risk was assessed at 1 per

cent, bank 2 could buy risk insurance for that amount, creating a net

asset worth 99 per cent of the loan. Now that it "owned" this asset,

it could further lend out as much money, without allowing its

liabilities to exceed its assets.

Two major points are worth noting here—first, derivatives are exempt

from central bank rules on cash margins; second, the role of rating is

key. If the risk attached to the loan is 10 per cent, then money would

be created in a rapidly decaying loop, like the cash-bank stream. If

it is 1 per cent, the loop is huge (99, 98.01...), generating vast

amounts of credit.

This highly-leveraged system largely created by home loans, supplied

liquidity. It's fuel was cheap money supplied by the US Federal

Reserve, but it fed money managers in Europe and Asia too. As long as

housing prices (and share prices) rose, the risk attached to MBSs (and

other derivatives) was low. More and more people bought houses they

didn't need or couldn't afford, creating a big bubble. When housing

prices began to drop, as they were bound to, the defaults began, and

the risk attached to MBSs rocketed. If the risk attached to an MBS

went from 1 per cent to 2 per cent, the bank holding it suddenly

needed twice as much capital. But so did everybody else. So, credit

was suddenly tight. This simplistic picture was horribly complicated

by the vast range of derivatives in the market.

In 2002, Warren Buffett warned that derivatives could create such a

"liquidity crisis (which) may, in some cases trigger still more

downgrades. It all beco-mes a spiral that can lead to a corporate

meltdown".

Unprecedented leverage created liquidity worldwide. The unwinding,

too, will happen across the world, but not overnight. Be careful. And,

if you are patient, it will offer many buying opportunities.;