The main cause of the 1929 Great Depression was the expansion of liquidity in the 1920s that led to a credit-driven boom which was not sustainable. The American government’s efforts to prop up the economy after the crash of 1929 made things worse. Some experts believe that the government’s intervention delayed the market’s adjustment and made the road to recovery harder.
The root cause of the current crisis has a similar pattern. It all started a decade back with a booming housing market in America. This boom was later fueled by expansion of liquidity in the system in the form of ‘mortgage-backed securities’ and ‘collateralised debt obligations (CDO)’ invented by Wall Street.
In the first few years of the boom, there was just too much demand for all ‘investment-grade’ properties as the same were used as underlying assets for CDOs. When the ‘investment grade’ CDOs saturated, investors started looking for sub-prime borrowers. Mortgage brokers and mortgage lenders were more than happy to look for ‘anybody and everybody’ who wanted a mortgage, (which, in simple terms, means a home loan.)
As a normal lending practice, banks or financial institutions ask for documents to verify income levels, ability to service installments, credit history and a lot more. One can also be asked to arrange for a down payment as margin money between 30 to 40 per cent of the asset value to cover the downside risk.
In case of sub prime lending the borrowers were always given favorable lending terms to the extent that in some cases neither margin money nor credit history were asked for. And most of the borrowers probably had no ability to service the installments either. It was a perfect recipe for disaster.
Is sub-prime lending only about the American housing sector? And if yes, does it mean once Capitol Hill clears the ‘700 billion Wall Street bailout plan’, all the problems will be solved and we’ll be back on track? The answer is a BIG NO.
Though we were led to believe that sub-prime lending so far is about American housing and mortgage repayment problems, it is one of the biggest lies of our times. There was simply too much liquidity in the system which forced bankers to fund sub-prime borrowers. The same practice helped banks inflate their earnings and profit forecasts and in-turn their valuations. The same bankers diversified globally into practically ‘anything and everything’ and funded or helped fund virtually ‘anything and everything’. A case in point is emerging countries and BRIC countries.
The bankers came up with all kinds of synthetic swaps and credit swaps to cover the risk of funding such economies. In the last ten years alone, BRIC and other emerging nations raised more than 1 trillion USD of capital most of which originated in Europe and America. The bankers used ‘convertible bonds’, which were covered mostly by a ‘credit linked note’ or ‘credit default swap’.
It is this market which may create the next round of heart-burn as the credit quality of assets funded by such instruments in a lot of the cases is below par and risky in nature. This is a virtually unregulated market with no fair value accounting practices being followed by a lot of the participants.
Unlike the sub-prime housing market, it is easy to price such instruments at par to markets? Should it be at par? But most of the below par papers are priced at par assuming the risk is covered by ‘credit linked notes’ or ‘credit default swaps’.
It is this assumption which may go wrong assuming a global economic downturn and a continued squeeze of the credit markets takes place. Rolling over them will become impossible. Instance of borrowing entities defaulting will be on the rise, resulting in more and more Investment Banks, Commercial Banks and Participating Swap Dealers raising capital and writing off potential losses which could be in billions of dollars.
The next category of problem is the CDOs structured in global markets, especially in emerging markets. With lack of liquidity, lack of government intervention and overall slow-down of the economy with a continuous credit squeeze, most of the structured CDOs which are covered with swaps will face defaults, in turn affecting the financial health of lenders.
‘Structured products group’ at every investment bank had an envious position during the bull run as they always had some or the other structure available to fund any ‘special situation’ for most of their clients. In fact, it became so easy for them to fund anything and everything that an Indian barber shop chain decided to do a private placement and subsequent IPO for their proposed expansion.
What it means is there was just too much liquidity in the system and it was flowing from every direction. Something similar to what we witnessed in the 1920s. The liquidity helped global markets in the 1920s to achieve new record highs. We’ve witnessed a similar pattern in the last decade too, when liquidity helped markets globally reach never before highs.
Equity was scarce and short in supply. People were buying shares as if there was no tomorrow. Hedge funds were investing into ‘anything’ like nobody’s business. Business class in flights from New York and London to Asia was going full with mostly traffic from hedge fund managers and investment bankers. Brokerages were giving leverage to clients to buy practically every junk stock around. It was a mad world full of people wanting to just invest into anything at any cost.
Come on, it can’t go on forever. The show had to stop somewhere and somehow. And indeed, it has stopped now, thanks mainly to the contracting of the money flow. A contraction of liquidity and money flow means that banks don’t lend even to banks, hence no question of credit for brokerages, hence no leverage for investors, hence no inflated positions with the result, that no new historic highs for markets.
Now contraction of liquidity means no aggressive lending, which, in turn, will affect roll-over of existing leverages, forcing most of the lenders to wind up outstanding positions before the underlying assets start falling in values. This may have a downward spiraling effect on stock prices.
The unwinding of leverage and lack of support at lower levels for stocks means lower valuations of equity at which most of the managements either will not raise equity, or simply can’t raise equity. With no equity and hardly any credit, most economies will go through a phase of consolidation. There will be more and more bankruptcy at the level of small and midcap companies. Big companies will start swallowing their smaller rivals. And that’s where the similarities between 1929 and 2008 ends.
The Great Depression of 1929 was all about America, Europe and Australia, with very little or no impact on Asia. Most parts of Asia and Africa were colonised by various European countries. Middle East did not exist. Japan was in ruins. Petro dollars had not been invented.
The Great Depression of 2008 also originated in America. The aftershocks will continue to be felt in the coming years. The impact will last for years. American investors and investment bankers always had an edge in innovating new products and taking risk and going to uncharted territories. The beta version of the ‘Great Depression 2008’ will squeeze their ability to take risks.
The new world order will be ruled by the petro dollars of the Middle East and Norway and traditional Japanese banks supported by other sovereign funds. China will emerge as a true financial super house with CITIC playing a major role in the next round of bull-run.
The next round of bull run will take at least two years to start and will be driven by a ‘resources and commodities’ boom in Africa and led by China. Japanese banks will be busy swallowing Wall Street’s prime assets. The petro dollars of the Middle East and Norway will end up swallowing major American banks.
India will be completely sidelined for the next one year. All major funds will wait and watch as there was just too much froth in the system. India also lacks timely intervention by governments to stabilise markets.
Whether we like it or not, we are in the second Great Depression, but unlike the first one of 1929, this time it won’t last long due to the presence of robust economies in Asia and the Middle East.
Author is Pankaj Shah, chairman of Earthstone Group, Indonesia