Subprime Nemesis

This quarter earnings have been very unkind to the global financial giants. The global corporate world witnessed billions of dollars write off, staggering losses in quarter earnings report, ouster of CEOs and top honchos.
When we had thought, the worst was over the ugly head of Subprime has again raised. The same rating agencies which few months back rated Subprime bond with highest grade has cut down its rating. Its biggest impact was felt by Investment banks which had high exposure to Subprime backed CDOs . The Investment Banks unable to find buyers for its CDOs have started writing it off from the books. The first jolt came in August when BNP Paribas wrote off $ 2 billion, which gave jitters to the global financial market.

But recently(18th Oct) the huge write off by Merril Lynch of $ 7.9 billion has left the financial market stunned. Adding to wound was the report that Merril Lynch still has a huge exposure in Subprime market and it is cleaning its balance sheet by transferring its Subprime investments to a hedge fund. Though the securities giant has vehemently denied the acquisition but still the damages were gigantic. The chopper fall on CEO Stan O’nell and board voted him out. The crisis triggered a alarm bell to Fed also which cut Fed rate by 0.25% to wade off the looming crisis. The rational of Fed’s rate cut has been questioned by many analysts who felt that with booming asset prices it will further fuel the inflation.

The report cards of all the financial giants across the globe has come as a dampener. The total reported losses till now due to sub prime has reached a gigantean aggregate of $ 55 billion. When every time we thought that the mess of Subprime was over more write offs resurfaced. No one for sure knows how big and how much more of sub prime is left in the books of the financial giant.

The current crisis has also questioned about the rationality of the investment banker. From the annuls of the history all the major crisis has been exacerbated by the investment bankers. The investment banking business got a major setback during 1998 financial crisis by the collapse of Long Term Capital Management. The dot com bust in 2001 again brought huge losses to the investment banks. Post dotcom in soft interest regime investment banks raised like phoenix and made huge profits. It lead to huge build up across many asset classes but soon bolt in the blue came from Subprime defaults. Till now investment banks were making hay but the sun has set now. The banks are playing safe by focusing on asset management and wealth management and avoiding risky assets. But investment bankers have always reverted back from the lows and have created new booms. It will be a eager wait to see what will be the next bubble that investment bankers spawn.

Global Financial Imbroglio

The popular belief is, what goes up must come down. If that is to be believed then where is our global economy heading. After a few years of great run up, in the valuation across all the asset classes, the decelerating forces have raised its heads. Since, the start of this year ,pundits’ prediction of a slow down in US economy has started sounding logical. They have always doubted where the US economy is heading with such a huge increase in budget deficit. The excessive consumerism backed by heavy borrowings by US citizen had its nemesis in the form of “Sub prime mortgage crisis”.
Technology, liberalization, globalization, lead to easy global fund flow and gave rise to “Carry Trade”. In February 2007, when Bank of Japan raised its interest rate from 0 to 0.5%, the jitters were felt across the global financial market. . The precedence of “South East Asian crisis” came back fresh into the mind of people.
The history of last decade in financial market has been cyclic in nature. The booming economy of South East Asian tigers got punctured by Asian financial crisis. The two major factors causing the crisis were the US economy’s recovery from recession and the raise in the Fed rate. Next came in the Information Technology boom followed by a gold rush in dotcom. Cashing on the euphoria dotcom companies started entering primary market. Investors forgetting the basic principles of investing, of investing in companies with sound business models, soon faced the hard reality. The bubble begin to burst and final nail in the coffin came as a form of 9/11. What followed was a period of recession.
The period of 2002 to 2005 under the guidance of Alan Greenspan saw cuts in the interest rate from 6% to 2%. The pumping of money by Fed into the economy lead to a rally in stock prices followed by other assets. Most importantly, it led to a boom in housing. Ultimately the boom busted in the form of Sub prime crisis. Subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. The repercussions led to consumer spending going down, the credit crunch, the slump in housing market and jitters in stock market. The economy is so threatened that the Federal Reserve set aside its worries about inflation and on September 18 cut short-term interest rates by half a percentage point for the first time in four years, hoping a shot of stimulus would head off a recession. Commodities had the biggest monthly gain in 32 years, led by wheat, crude oil and gold, as the dollar's slump enhanced the appeal of energy, grains and precious metals as a hedge against inflation.
Are we heading towards softening of interest rates? That the coming time only will tell. But, whatever be it, Fed must be cautious in reigniting inflation and spawning new bubbles. Japanese economy is showing signs of recovery. If that sustains then we will see hardening of interest rate by Bank of Japan which will lead to unwinding of carry trade and lot of global trembling.
India also had its dream run up in the global boom. The commodities, real estate and stocks have sky rocketed. Though the rally is suppose to be backed by fundamentals of India growing at fastest, but are we enough shock proof ? After a dream run up Japanese economy cooled down, so did South East Asian countries. Now, the onus is here on Govt. and RBI to keenly follow the development and formulate maximum risk management strategy.