People are skeptical about market: Chairman of Earthstone Group

Mumbai, Sept 25 (ANI/Business Wire India): Financial markets are all about confidence in the system and an underlying assumption that system will not fail. But, after the bankruptcy of Lehman Brothers in USA and Northern Rock in the UK and the bailout of Fannie, Freddie and AIG investors, people have lost confidence in the system. In fact, some people have even started being skeptical, if any system exists at all.

Their doubts are not unfounded as the tricky web of Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO), which are traded privately and no one, including SEC, FED or the US Treasury regulates them.

There is an unregulated trillion dollar market which has no system in place to track, follow and regulate the flow of deals and transactions. It all started with the boom in the US real estate market a decade back.

The cheap credit fuelled the real estate rally for almost a decade. The innovative Investment Bankers at Wall Street wanted a pie of the action and devised some new innovative instruments like mortgage-backed securities and insured them with Credit Default Swaps.

It was a great innovation as home owners got cheap credit hence they kept buying more and more. Mortgage companies then started packing these mortgages as underlying securities and sold and resold them through investment banks.

Lehman and Merrill who were initially acting as Investment Banks eventually ended up buying these securities by leveraging with Commercial Banks like UBS. Next, UBS funded securities like these, by innovating Credit Default Swaps insurance in case of a Credit Default which was written mostly by firms like AIG.

Everyone thought they were safe. The Mortgage Banks were the most to benefit as they were able to lend more and more and make the spread. Investment Banks made profits in brokering the deal and eventually started making spreads. Some of them even took principal positions in some projects and benefited due to real estate prices going northwards.

The liquidity was just too much. It was a classic situation where banks wanted to fund anything which was collateralized by assets and packaged as a product insured by derivatives like CDS.

This is where Investment Banks and their thirst to increase their bottom lines came in to the picture practically. When the Prime Lending saturated, they started to hunt Sub Prime Borrowers and mortgage companies who were specialists in Sub Prime lending (Sub Prime Lending basically means lending to those who do not have a good credit history, with loan and credit card defaults, who otherwise do not qualify for a loan at prime lending rates.)

The sub-prime lending market peaked in 2007 with cumulative lending of more than 1.5 Trillion USD. Most of which was funded by mortgage backed securities sold to or through investment banks to commercial banks worldwide including banks in Europe and Japan. Firms like Lehman leveraged 30 times of their asset base. For every one USD assets, they borrowed 30 USD, and the enormous leverage left hardly any room in case of a fall in real estate prices.

With the bubble bursting in the US real estate market with more and more borrowers failing to repay and refinance their mortgages, the mortgage backed securities which were collateralized started falling in value; the fair value accounting practices becoming the biggest problem for investment and commercial banks.

When the underlying asset starts falling in value, a borrower must top up the margin. Now there were two problems, how to value the asset and how to calculate the Mark-to-Market margins for such securities which always traded privately.

For the first one or two quarters, no one really knew how to price them and how to decide on the losses and write them off the books. Investors faced similar problems in understanding the complexity of the whole thing.

The likes of Merrill, Citi and AIG raised more than 70 Billion USD during the first phase of the crisis.

By the end of phase I, everybody realized it's next to impossible to price them and get the mark-to-market value for them, which means, they're as good as junk and need to be written off 100 per cent, and by doing so firms like Lehman, Merrill and even Morgan had no other choice other than to raise capital or find a merger partner or to go bankrupt! Merrill and Morgan were lucky as the Government came out with a bail-out plan, which if it had come a week earlier, could have saved Lehman.

The crux of the problem was that innovative investment banks created a web of derivative instruments which traded privately in a completely unregulated environment.

Plenty of leverage for all and sundry with no room for errors relying more on instruments like CDS to cover the risk without actual ownership of the asset or knowledge of the credit quality of the borrower was the heart of the problem.

To a great extent the bail-out will help, as it will provide liquidity of non-liquid securities and help banks to get rid of toxic debt paper. It will bring back much needed liquidity in the system, which means banks will start lending again, and that will help stabilize the ailing real estate market.

'Confidence' will be 'Restored' in the 'System' and those seating on cash will start participating again, which in turn will help to stimulate global economy. Sovereign Wealth Funds who are seating on cash because of the commodities boom last year and are on the sidelines will be able to pitch in.

What the bailout plan really offers banks and financial institutions is a window of liquidity to dump the non-liquid mortgage backed securities which are not trading anymore on the Wall Street. The big problem will be how to price such securities which have always trade privately. This is where the banks may lose more, but at least they'll be able to exit such investments and limit their losses.

China has a robust Domestic Capital Market and Institutional mechanism to help the markets recover. The government is pro-active in taking steps to calm investor worries and has enough forex reserves to weather any storm.

USA will go through the pains for one or two more quarters but eventually recover. As the confidence returns to the 'System', the likes of Morgan and Citi will be able to raise capital once again. Most of them will want to off-load part of their toxic debt to Fed but will still want to keep a major part of it on their balance sheet as that's where they can have an upside once the real estate market revives.

As the bail-out plan is valid for two years, most of them who can raise capital and afford to keep these junk on their balance sheet will want to wait for at least 18 months for a real estate market revival which can give them a huge upside as most of them have already taken the hit. Worst case scenario, they can off load everything to Fed before 24 months in case of no revival, but the expectation of revival will fuel a rally in American markets.

European Banks have limited exposure from now on as most of them have already taken huge hits in the past 3 quarters, but the Wall Street bail out plan doesn't offer them anything in particular. Europe will continue to trade in the sidelines.

Japan will go through an interim recession as Japanese banks and institutions are the biggest losers in the present crisis and a tricky political situation and lack of government intervention, will slowdown the pace for lending and credit which will slow down the whole economy.

Emerging Markets will witness a short term rally but investors will want to sell at every level as they're hit the hardest due to lack of liquidity and are also amongst the most thinly traded markets. Investors will use every opportunity to exit from junk and dud stocks from these markets but the bluechips will be favored again. In short there is no hot money chasing the dud and junk stocks anymore. There will be smart money chasing fewer bluechips, which will result into indices going up but won't result into an all-out rally and boom in capital market in emerging countries.

Indonesia is fairly insulated from the present crisis though it's heavily dependent on foreign investors for liquidity in the markets, slow down of foreign investment may impact trading volumes for some time. Coal prices will cool down in short term as demand from India will decrease as financialclosures of major power projects get delayed due to present market conditions, which in turn will depress the commodity driven Jakarta Index.

In short there are no free lunches anymore; we all have to work really hard to make every penny in the market.

Author is Pankaj Shah, Chairman of Earthstone Group, Indonesia.

ANI