Rate Cuts, Trusts, Banks and the Summer of 2001

Surviving the Maelstrom that Lehm= an’s Failure set off in the Subprime Crisis

It has been a terrible October and the month is no= t over yet. There is no other barometer that so accurately reflects the appetite f= or risk-taking that is at the core of a market-based system, than the indicato= rs of capital markets – stock prices and bond yields: And these have been going haywire. Never it is being said have the inter-bank market frozen ove= r so much or the spreads between corporate and government bond yields been so wi= de, or stock markets fallen so far and so fast. However, that is, not entirely = true. In previous crises, credit market problems in developed markets have not be= en the driving force of the troubles, so the freezing over of bank credit, at leas= t in modern times, is perhaps new.

The experience with stock markets this time is not= entirely different from previous episodes; although the rapidity of change has been = much greater. When the dotcom bubble burst in early 2000, US and major European stocks mostly inched up to September of the year and only then began to sli= de. That slide lasted two years before finding a bottom. In the first year, the US S= &P500, the UK FTSE100, the German DAX and French CAC40 lost between 33% and 37% fr= om their peak values and then went on to lose a total of between 46% and 55% at the end of the two year period. In Asia,= Hong Kong, Seoul and Mumbai all began to lose value after February 2000 and by September 2001 had lost between 48% to 50% from their peak and found bottom.

In the current episode, US and most European marke= ts, Australia, Seoul & Hong Kong touched peak in October 2007, while India and some ot= her Asian economies did so in January 2008 and Russia and Brazil in May 2008. In this short span of 5 to 12 months markets have on average lost half of their value. The US Dow Jones Ind.<= /st1:place>, US S&P500, UK FTSE100, German DAX and French CAC40 have lost between 40% and 48% at their recent lowest closings from their 2007 peaks. Australia and Seoul are down by 42% and 49%; Brazil and India are down by 52% each and Ho= ng Kong by 56%. Both Ru= ssia and China have fared worse. Shanghai is down 69% from its October 2007 peak, while Ru= ssia (RTS) is down 70% from its May 2008 peak. So much damage wrought in less th= an a year, in some cases in a matter of mere months.

Not only is the range of price decline, 42% to 56%, similar across economies, the range of variation is truly narrow, if we loo= k at the decline since 12 September 2008, the last working day before Lehman was allowed to fail. The decline between 12 September and the lowest point in t= he October market was 25%–29% for US DJIA, US S&P 500, CAC 40, DAX, = UK FTSE, Australia, Seoul, Hong Kong and India BSE 30. For Brazil it was 33%. A hopeful view could be that the fall of Lehman brought the unwinding of asset prices forward by one year. The other is that letting Lehman go was a terri= ble misjudgement that has hurtled the crisis and the world down an entirely different and mo= re dangerous path. This columnist subscribes to the latter view.

Not only has the speed of price decline been precipitous the extent of correction has already been as deep as that in the bursting of the dotcom bubble. Does that mean that a bottom has been found?= We do not know. For one thing, in 2000 the valuation problem arose on the equi= ty side, while the credit side was relatively unaffected. The recession that followed both in the US and Europe was not driven by a financial crisis and= to that extent were traditional downturns. This time around, it is the develop= ed credit markets that have been deeply affected. Enormous public investments are bei= ng made in the private sector banking of these economies, in anticipation of l= arge loan losses that might have to be taken in the foreseeable future. Equities= in the US and Europe are suffering not on account of valuation excesses, though some may argue that some of that was there in emerging markets. =

The first proximate cause of the pain was the panic that accompanies a banking crisis, which was what one got after 12 Septembe= r through the end of last week (17 October). The second factor that has sequentially kicked in this week is expectation that recession will drive future corpora= te earnings down and for how long is as yet unclear. Thus panic (irrational) h= as yielded to rational price discounting and therefore volatility is down.

It may not be advisable to look at previous crises= to gauge how long the recovery this time will take. For the record in the early 1980s and 2000s, the bottom was found after 24/30 months and recovery (from= the much reduced levels) began thereafter. In the Asian Currency Crisis, in most affected markets, the bottom also took about 2 years to find and recovery followed. However, the jury is still out on how deep the US and European recession will be this time.

There is one thing that is nevertheless certain. In those economies where economic growth does not falter much and corporate earnings recover earlier than later, the capital markets will follow. This = is however a bit of a chicken and egg story, since the principal reason for gr= owth (and corporate earnings) to weaken in economies like India, will be the combination of restricted credit flow and difficulties facing companies in raising capital – both equity and debt.

Sharply reduced commodity prices and much lower gl= obal inflationary pressures (in the near term, though not in the medium term) are certainly helpful. These developments also serve to lower the prospective f= uel and fertiliser subsidy burden and thus ease the pressure on the fisc. Policy should thus be biased towards easing the financing constraints that affect = both asset creation and leveraged consumer demand. Funding flows within the exis= ting architecture of the financial system has and will be a problem and steps th= at combine prudence, necessity and innovation can play a big role in helping growth to stage an early recovery from the current crisis.

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The Economic Times: Friday, October 24, 2008

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