Science of Financial Markets- Can it explain the current Credit Crisis ?

I am suddenly nostalgic being in Asset Management class at Warwick Business School…I remembered my science classes in school.. In 10th grade we learned about the Big Bang Theory and the concept of black holes, white dwarf, etc.

These concepts I guess I can relate to what is happening now in financial markets. A Big Bang has taken place. And the financial markets are shrinking rapidly and are pulled towards their origin by the strong forces of greed, contamination and deregulation. This will result in creation of black holes. In this black holes, the gravity of these forces will be so strong that not a single ray of light can pass through it. I am not exaggerating the magnitude of financial crisis, I am trying to show its impact. Its more than just a financial crisis.

Probably not many people will believe that few people in the industry had predicted this Sub-Prime crisis as early as 2005-2006. Warren Buffet and other notable experts in the filed have recorded their statements that USD will depreciate in future and is in a long term depreciation trend. To add to this, I had presented a similar report in my college in 2005 on the same issue of Sub Prime crisis and tried to evaluate the housing market in USA and tried to identify the asset bubble in making,. In addition, I extended my framework to include gold as an asset class rather than an commodity and pointed out the possible scenarios where gold would outperform the other asset classes. In my report, I clearly mentioned that the spectacular credit growth which led to inflationary asset prices could not be sustained in future and would lead to creation of circumstances which will lead USA and the world economy into a vicious cycle of recession. It would lead to a combination of depreciating dollar, rising interest rates, high unemployment rates, defaults in housing market. And now, the results are in front of us.

Rationale:-Behind Crisis

The reason is very clear whenever anything rises at alarming levels it has to come down at similar periods. Again, I would like to relate this to Newton ‘s Gravity Theory. Issac Newton discovered the Gravitational Theory and concluded that any thing that goes up has to come down back to earth and the speed at which it comes down is faster than it goes up. So please remember these theories and concepts, it has indirect applications in finance. So if you scored well in science, you would score good in finance. In past four years, stock markets experienced spectacular Bull Run and the equities zoomed as if USA & Russia were releasing rockets from earth. But every bull run teaches its own lesson. In 1990’s after the dot com bubble, people became wary of high P/E multiples as high as 100-400 times which were allocated to dot com companies. In fact, for some time when the returns were generated and people who bought these stocks at 100 P/E ratio were able to see it to another fool for 300 P/E ratio, even investor like Warren Buffet was astonished and made public statement that for the first time his research was wrong and probably market was right in its judgement. Soon after he made his confession, in few months the dot come bubble took place and stocks went crashing. After 2008 crisis, people in future will understand the importance of identifying risk involved in asset, its payoff and associated cash flows.

Had government exercised effective regulation and control on the financial system and imposed stringent capital adequacy norms, the present situation would not have arose. Hedge Funds in US were completely unregulated and there was no check on their activities such as speculation, high leveraging etc. In fact, hedge funds used to go to havens like Bermuda, Mauritius etc to escape from regulation. In past decade, the financial markets made easy for I-Bankers, Hedge Fund managers to earn quick buck. Most of the analyst were new and just experienced the bull run and had never experienced bear run. Thus any stock selected by them performed well in the bull run because of systematic return ie correlation with the index. So they never actually knew how to pick growth and quality stocks, nor could they read off balance sheet items and secret reserves build by the company. People like Warren Buffet understood financial statements and made money. To add to this, when Warren Buffet was asked what do you think your successor should be good at ? He said that my successor needs to be able to analyze the financial statements and especially the off balance sheet items.

Another reason is the unaccounted investments of Hedge Funds. This are specialized institutions that are willing to take risk and beat the market and generate excess return on investments and are looking to make a quick buck in short time. South East Asian Crisis is an example of how can these short term foreign inflows and outflows can distort the BOP of an economy. These funds invest money in un chartered territories and seek advantage of being first mover. Due to their high bulky investments, they attract market attention to that particular asset class. For instance, since 2005 the money flowed into the Equities, mortgage backed securities and other riskier assets. The result bull run in equities. Retail investors entered at peak and are in losses, while hedge funds exited at profits at peak. Then this money made way into commodities like Crude, Base metals, precious metals, agricultural commodities etc. And suddenly the commodities started experiencing a bull run. Crude rose from $70 per barrel and reached sub $150 levels in a short period of time. There were no fundamental reason that justified the magnitude of rise in such a short period of time. And as expected when on corrections, hedge funds were exiting and booking profits, retail investors entered and booked looses. Now the money has flown out of crude and will look at gold as its safe heaven. Gold., as in investment class will be looked upon by investors in next 2-5 years to beat inflation and for safety of capital. One of the reason for the large size of hedge funds was the sheer number of funds launched in short period of time. In Wall Street, any I-Banker with an Ivy League MBA could launch his hedge fund and within hours he would get several billions to start his fund. This unregulated industry presented data of its best fund to raise capital and the funds which failed were not reported at all and thus returns which were reported were biased and misled investors.

Another important reason for the crisis has been structured derivative products and its complexity. The main aim of the derivatives was to enable asset holder to hedge his risk. But the doctorates in physics, math, statistics and ones from engineering background created complex derivatives products whose pay off were not easily determinable and hence the clients-corporates could never understand the risk associated with the product and its pay off. Thus when markets reversed, as in case of Indian IT industry, on one hand they had windfall gain due to depreciation of ruppe on other hand losses from hedges. These left their balance sheet red. The creators of structured products themselves never understood the product and its implications and hence could not analyze the product because they lack the knowledge of financial concepts etc.

Impact of Credit Crisis

The impact of crisis can be measured from the following facts: Fed Reserve has injected 700 billion USD into the system, BoE has injected more than 400 Billion GBP into the system. Bear Stearns and Lehman Brothers have been bankrupt, AIG suffered huge losses and Fed Reserve had to intervene to protect counterparties which were predominantly pension funds, retirement funds etc. Iceland ‘s banking system has collapsed. Russia is seating on around 250 billion USD and is bailing out Iceland, but guess that wont be enough and Iceland is very angry as none of the Western Counterparts are willing to help. The reason is evident, Fed would handle its own economy or Iceland? ECB has asked its member nations to develop their own plans to bail out their domestic banks and central banks throughout the world have coordinated their monetary policy to ease the tight liquidity position in the money markets. The money markets have literally frozen. With LIBOR rising as high as 5%. Nobody is willing to lend in the money markets and after 2001 for the first time there have been such heavy withdrawals from money markets. The banks are trying to recapitalize themselves and holding every penny of money. This has adversely affected the expansion plans of quality corporates because the debt markets have literally frozen. Banks firstly don’t have enough money to lend and secondly they perceive the credit risk is too high.


Will Bail outs be effective? I doubt

I would like to point out that the bail out plans of Fed Reserve and BoE will not necessarily solve this issue. Market will take its own time to assess risk and adjust accordingly. In many of these financially important centers, the size of the banking system exceeds more than 5 times the size of the economy. Take for instance UK, the size of the banking industry is more than 5 times the size of the GDP. This means recapitalizing banking system by 1% requires 5% of GDP borrowing. Thus even a small 5% recapitalization plans would require more than 25% of GDP borrowing and that would take already high levels of Fiscal deficit to still higher levels leading to higher inflation and higher unemployment rates. So here one can see how much dependable these bail outs are. Moreover, higher levels of fiscal deficits would still requite high levels of taxes, which is not possible because slowing economy would reduce incomes and hence the tax collections. The more interesting part is to see how does government handle the defaults in newly nationalized banks like RBS. Will government exercise its right on the collateral to recover loans and ignore that it is responsible for the plight of its citizens.

The current situation relates to Liquidity trap as described in the Keynesian Economics. Eventually, the rate of interest will fall so low that this will lead to an infinite demand for money. As it has been in Japan, where the real rate of interest has been negative for more than a decade and property prices are at 40% of their peak in 1990’s. Until, the credit markets are not stabilized and the confidence levels are restored in the credit holders I don’t see any ray of light in the black hole. For the first time, have investors learned their lessons by not caring out proper risk identification. In last crash in 1987, only the equity holders lost money but the debt holders didn’t even when the bankruptcy was declared. So these were considered to be safe, for the first time has the write downs have been to such a large extent that they have completely wiped off bank’s balance sheets and curtailed their ability to raise capital. This has lead to default and for the first time will the credit holders will suffer losses on a wide scale. A research has even pointed out that sovereign bonds which are said to be risk free are essentially not risk free and more than 27 sovereign bonds have defaulted. Moreover, these carry interest rate risk, purchasing power risk, exchange rate risk for international investors etc. So essentially the concept of risk free rate does not hold true. And investors need to price in the extra risk premium. This will lead to re allocation of wealth among various asset classes. The rate of return required from a bond as compared to earlier (ceteris paribus) would rise significantly and this would have deep impact on the bottom line of highly leveraged companies and would render most of their projects unprofitable and may even force them to delay projects due to non availability of cheap and required capital. Thus only companies which have adequate capital to fund their expansion plans and have strong operating cash flows would survive. That’s why adage goes’ A money today is better than money tomorrow’ and every business should have enough cash to take advantage of market imperfections and opportunities.
Central Banks are cutting Discount rate steeply because they want to improve the liquidity in the system and ensure that there is enough capital in the system but it fails to realize that this money is just finding its way into the treasuries of banks and in reality wont be made available for lending. In fact, one school of thought believes that the rate interest should rise sufficiently to compensate the investors of credit and interest rate as well as purchasing power risk. Only when the rate rises significantly, will investors opportunity cost of money will rise and they part away with money. The speculative demand for money will reduce and money will be deposited with banks and made available for lending. The reason being that the demand for speculative money reduces as the rate of interest rises.

Paradigm Shift-From deregulation to nationalization
Few months back, inflation and rising crude prices was a big concern and suddenly the focus has shifted to more important events like nationalization of banks in UK, USA etc. See the irony, few months back developed economies like USA, UK, EU were advocating liberalization of financial services industry, free movement of capital, deregulation of financial services industry, denationalization of banks and privatization bla-bla . What has happened now? The same nations are now harping the tune of nationalizing banks and using tax payer’s fund to recapitalize national banks and save their banking system from collapsing. Few months back, London and New York were the teller counters of this world economy and whoever wanted money went to these counters and raised money; whatever may be the need speculative demand or investment or consumption demand.