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Meltdown deconstructed

business Updated: Oct 14, 2008 00:26 IST
Niranjan Rajadhyaksha
Niranjan Rajadhyaksha
Hindustan Times
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A doctor friend recently told me something interesting. The doctors’ lounge in the Mumbai hospital where he works has a television that was usually tuned to one of the business news channels during the bull market that took Indian shares to record heights by January 2008. Cardiologists and urinary tract specialists spent time between operations listening to the latest recommendations from analysts and exchanging stories of profitable trades.

That television is now on mute.

These doctors now scan the tickers that silently flow across the screen, carrying grim news of portfolio losses. They are not alone. Across the country, investor wealth has reduced by Rs 37 trillion because of the sharp fall in share prices from their January peak, despite the splendid recovery on Monday.

Most investors find it hard to understand why share prices are tumbling in an economy that is nowhere near recession. That’s because problems that started in the US and Europe last year have jumped across oceans like a virus.

The first sniffle was heard in the summer of 2007, in what is known in America as the subprime mortgage market. But the story starts a few years earlier. The dotcom bubble burst in 2001. As the US slipped into recession, the US Federal Reserve cut interest rates by flooding the economy with extra money. That made it easier for people to borrow to buy cars, washing machines — and houses.

America went on a home buying spree. Real estate prices were rising rapidly. The boom in housing prices made both banks and homebuyers believe that the price of a Florida condominium and a New York apartment would keep going up. Housing finance seemed a very safe bet.

Banks went out of their way to lend to subprime families, or those who had a history of not paying back their loans on time. One innovation was the Ninja loan, an acronym for loans to families that had no income and no assets. Ninja loans were one road to financial hara-kiri.

All this was fine as long as housing prices were rising. But the housing bubble burst in 2007. Prices fell and subprime borrowers started defaulting. The banks had to report losses.

That would have been the end of the story, but for two other factors. The banks that sold subprime housing loans did not hold onto them. They sold them to other banks and investors through a process called securitisation. Wall Street investment banks repackaged loans into synthetic securities that were numbing in their complexity.

Investors need to know what they are buying. You can see for yourself if a tomato is rotten. But a complex financial security that has been created by mixing hundreds of thousands of independent loans can fox even the smartest investor. Specialist agencies tell investors how safe a security really is. But these credit rating agencies did not do the job well enough. All sorts of rubbish were sold as good stuff.

The final problem came from leverage. Investors bought mortgage-backed securities by borrowing. Some Wall Street banks had borrowed 40 times more than they were worth. How dangerous is that? Think of an inverted pyramid — impressive till it starts swaying in the wind.

The system went into reverse gear after the middle of 2007. US housing prices fell at their fastest rate in 75 years. Subprime borrowers started missing their payment schedules. The banks and investment funds that had bought billions of dollars worth of securities based on mortgages were in trouble. They faced losses. Worse, many complex securities could not be valued at all. Banks first reported huge losses. Then a few went bankrupt.

It is impossible to know who is in trouble and who was not. In this mood of pervasive fear, banks have stopped lending to each other in financial centres such as London and New York. Banks are no longer interested in playing a variant of passing the parcel. The financial markets in the West have frozen in panic.

Leveraged investors have had to return the money they borrowed to buy everything from shares to complex derivatives. They sell to raise the funds. That sends financial prices even lower, which leads to further pressure to deleverage, which leads to further selling and so on.

All this led to massive bailout packages in country after country, as governments stepped in to buy and lend in a financial market that is on strike.

And what about India? The foreign money that flowed into the local stocks during the bull market has reversed course because of a global financial crisis that has been billed the worst in 100 years. Global investors have already sold more than $10 billion of shares this year. Shares prices have dropped like a stone.

Foreign investors have to convert their rupees into dollars on the way out. This has pushed the rupee down to record lows. To prevent a complete rout, the RBI has sold billions of dollars from its reserves and bought rupees. Each sale of a billion dollars sucks around Rs 5,000 crore from the domestic money market. There are not enough rupees to meet the economy’s needs. The rates at which banks are lending to each other and to companies for short periods are at their highest levels in many years, though longer term loans have not shot up to the same extent.

The problem that started with growing defaults by poor American families the middle of 2007 has now hit the Indian economy with the force of a hurricane.