The coming financial tsunami



17th Dec 2011


Shareholder capitalism has gone overboard, and we are going to pay a heavy price for it. In the '80s the economies of both Japan and Germany had grown and were threatening the hegemony of the US. In early 80's 3 of the top 10 banks were Japanese, Sony bought Universal Studios, NTT DoCoMo was the most expensive stock in the world and Japan bought Rockefeller Centre. The German auto and engineerin industries were challenging USA

Their success impinged largely on the stakeholder capitalism model both followed, in which all stakeholders were given importance. To counter it, the US strongly promoted shareholder capitalism, which gives more importance to the interests of providers of capital, and less to other stakeholders such as employees or suppliers or customers. It worked, and, alongwith its other pillars, such as its system of higher education, its venture capital industry and its judicial system, enabled the US to grow faster than other economies. Its GDP is over $ 15 trillion followed by Japan's at $ 4 tr.


The reason for this is that of the four factors of production, men, material, machines and money, it is only the last that is capable of digitization. It can thus move much faster than others, thereby having a greater influence compared to others. The weight of a factor of production is its quantity multiplied by its velocity of circulation.

Modern finance has further enhanced this velocity by creating derivatives of financial products and then, through securitisation, enabling the sale of these derivative products to the public after slicing and dicing them. The sliced products are rated by rating agencies, to make them acceptable to the investing public. This is how the subprime mortgage mess was created. US (later others) banks lent to ninja (those with no income, no jobs or assets) customers to buy homes, with zero collateral, as they had no assets. These ninja loans were then sliced and diced, and some parts of them even got AAA ratings by agencies! Amazing! An article in the Economist talked about a review of ratings given by Moody's, a rating agency, to one type of security called Alt A. At the end of a 5 day review Moody's downgraded over 90% of its own ratings from AAA to junk, in one step! That's insane!

Last week we got news at 3iInfotech's rating was also similarly downgraded by CRISIL to junk status, barely four months after it had re-affirmed AAA rating in August. How can this happen? Rating upgrades or downgrades are in steps, not in jumps.

Almost all European banks are in trouble today because of inordinate and foolish lending to sovereigns. Again, sovereign bonds were rated AAA on the basis that countries can't default. This has been proved wrong. Thus countries like Greece were lent much more money than prudent norms would warrant and, if one were to read the excellent book "Boomerang" by Michael Lewis, no one in Greece was keeping an account of spending. It was the same with Iceland, which was lent money at 14% interest, which was untenable, but used by its citizens to acquire all sorts of assets. These bubbles, funded by loose money, ultimately burst. Just as the US housing market did. Just as Iceland did. And Greece will.

Not only have regulators permitted the creation of derivative products (and derivatives of derivatives!), and allowed credit rating agencies to be blasé in rating them, but they have further compounded the problems by legally allowing misuse! This legal misuse was what brought down MF Global. It is well explained in an article by Christopher Elias. The FSA (Financial Services Authority) in the UK permitted securities which clients had hypothecated to brokers, to be re-hypothecated by the brokers! The US also permits this, but upto a limit of a shortfall; the UK allows it upto 100%. Since it is legally permitted, apparently the clients don't have a right on their own asset pledged as security! As per the article "A loophole appears to h ave allowed MF Global, and many others, to use its own clients' funds to finance an enormous $6.2 billion Eurozone repo bet." The bet went wrong and MF Global went into bankruptcy. The cost was borne by clients who had given security as collateral but had no claim on their own assets! How utterly corrupt!

So now European banks have lent against all sorts of funny and fuzzy instruments, including credit default swaps, and, since a lot of these assets have been securitized, nobody can really gauge the size of the problem. It is a financial tsunami waiting to happen.

That is why the euphoria, if any, over the Eurozone deal, which struck by the EU leaders last Friday, was shortlived. The problems of one country, especially a large one like Italy, could easily become an uncontainable contagion. It will spread to the US. Interbank lending will freeze, as it did after the Lehman Brothers' collapse; only this time it will be much worse.

The financial problems are compounded by global warming problems. These are caused by an overuse and exploitation of depleting natural resources. The deal to curb emissions, reached at Durban, is going to be too little, too late. Already countries like Canada have backed out, so that they do not have to pay the cost of polluting the environment, and others will follow.

What are countries doing to curb emissions? China has sensibly hiked import tariffs on criminally gas guzzling vehicles such as SUVs, making them thrice as costly as in the US. Why doesn't India do the same? Using excise duties for local manufacture, and import tariffs for imports, our Government should discourage the use of gas guzzling and fossil fuel resource depleting vehicles. It has not even bothered to mandate fuel efficiency norms. Why has not our Government built up an alternative, efficient, public transport system, in anticipation of the day (not distant) when private transport will become unaffordable. One wonders if banks will provide EMI loans to buy petrol!

The Government's big bang reform, FDI in multi brand retail, which it sought to introduce, was politically stymied and had to be shelved. Its other good idea, of the unique id project, or UIDAI, was stymied by a Parliamentary committee on which its own members were asleep. The GST bill has got nowhere. Also going nowhere is the Governments efforts, or lack thereof, to obtain details of offshore bank accounts held by Indians.

Apparently some of the banks have provided such details. Perhaps an idea the Government may consider is to offer the carrot of another amnesty scheme, offering a clean chit on payment of, say, 40% tax on the amount brought in before March 31, together with a stick of penalising severely those whose names appear on such lists, by prosecution, penalties, fines, disclosures and also arrest. If it succeeds, as it ought to, the fiscal deficit would be solved in one stroke.

Indians also have the world's largest horde of gold. Why doesn't the Government offer to trade physical gold with paper, bearing a low interest rate, with a guarantee to return the gold of the same purity, when asked for? Then use the gold to raise funds for 1. Physical infrastructure such as roads, power plants and ports and 2. Social infrastructure such as schools and colleges, training institutes, and hospitals. And not for its recurring expenses.

In corporate news of interest, Fortis Healthcare is under fire from analysts for poor governance, as it acquired, for $ 665m. the assets of privately owned Fortis International. The feeling is that the price was too high, and investors have sold the stock which has fallen 25% since the purchase, more than the 3.5% fall in the market.

The promoters of some companies had issued themselves warrants to acquire shares in their companies at a future date. Security And Exchange Board Of Indian (SEBI) mandated that 25% of the exercise price be deposited upfront, at the time when the warrants were issued. Accordingly, the promoters of JSW deposited Rs 529 crores. With the stock quoting some 55% below the exercise price, the promoters would tend to lose that amount. Similarly, the promoters of Pantaloon have to decide, by year end, whether to forfeit the initial deposit of Rs 100 crores, or to exercise the warrants and acquire shares, wh ich are quoting some 69% below the exercise price. Warrants have become double edged swords.

The CBI has charged Essar groups Ravi Ruia, Anshuman Ruia and CEO Vikas Saraf, together with IP Khaitan and Kiran Khaitan (sister of Ravi) of Loop Telecom, in the 2G telecom scandal, though Salman Khurshid has publicly stated that Essar was not in control of Loop.

The Reserve Bank Of India (RBI) left interest rates unchanged, which disappointed the market, which dropped to a 2 year low. Investors were hoping that interest rates would start coming down, as the economy is being visibly affected. The IIP (index of industrial production) fell 5.1% in November. The Government has scaled down GDP growth forecast for this year. AM Naik of Larsen & Tarbo (L&T) feels that GDP growth would be below 6% next year, as there is little capital investment taking place (thanks to high interest rates).

The BSE-Sensex dropped last week, ending down 722 points, to close at 15491. The NSE-Nifty fell 215 to close at 4651.

The rupee is also falling, going to a low of Rs 54.20 per US$ before sale of $ by RBI pulled up the Rupee. A wag says the next report on currency management ought to be named after the Hindi film, 'Ab Tak Chappan'.

We are also in for more political skirmishes. The Government is struggling to introduce a Lokpal bill in this winter session of Parliament but it is uncertain if it will fully bring the CBI under the purview of the Lokpal. It has been able to (mis)use CBI for its own purposes and is loath to give away the advantage. Anna Hazare is threatening a renewal of agitation if the Lokpal bill introduced by the Government is not to his satisfaction. Other, opportunistic, political parties will jump in and stir the pot for their own ends.

Several states, including UP (the largest, with the most seats in the Lok Sabha), Punjab, Uttarakhand, Goa and Manipur go to the polls early next year. Till these elections are over there can be no bold economic reforms as the Government does not have the spine. The market would continue to drift downwards and if it goes below 15,000 it could fall sharply further.

At some point in the future, earnings would have fallen enough and would start to rise. So would the Indian rupee, versus the $. Foreign investors would, if they enter before these rises, get a double whammy of increased earnings plus a currency appreciation. Add to that a re-rating, and higher P/E, it would become a triple whammy. So at some point in the future, the markets would bottom out.

That time is not now.


by Shri J Mulraj