Huff, Puff The House Is Down

• Crisis in subprime mortgages led to huge losses for many US players; no one knows the real extent of the problem
  
• Losses led to selling of profitable assets like equity holdings in emerging markets; others followed suit
  
• Unwinding of the Yen trade, forced on investors as borrowings in Japan became expensive, led to more selling pressure
  
• Hedge funds and FIIs sold shares in the Indian stockmarket to generate cash to pay to their shareholders
  
• Has led to an overall global credit squeeze due to a fear psychosis

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He doesn't believe in portfolio diversification. He believes in getting a few picks right and sticking with them. GeorgeSoros, Chairman, Quantum fund

"The stockmarket is like a fashion show. Amateurs watch the models, the pros watch the other pros."Jim Cramer, TV Investment Guru

"I think it's something more serious. It's a symptom of excessive credit growth that was encouraged by the Fed." Marc Faber,Investment Guru

"The situation has been exacerbated by securitisation. Once you package these things and sell them... discipline leaves the system." Warren Buffet,Chairman, Berkshire Hathaway

im Cramer, an American TV personality revered by investors, once said the stockmarket was like a fashion show. While amateurs watched the models, the professionals watched other professionals. In recent times, however, equity trading has become more like an acid trip—fear and loathing seems to have gripped Dalal Street and other markets in emerging and developed nations. On any given day, no one's sure whether the Sensex and other indices will witness ecstatic highs, depressing lows, or quiet sobriety.

Since July 24, 2007, the Sensex has moved between a high of nearly 16000 points to a low of under 14000—a change of over 12 per cent. On days like August 1 and 16, it dropped by over 600 points, creating panic. But then, there have been dazzling trading sessions, as on July 31 and August 8, when it zoomed by over 300 points each. The analogy looks pat: just like so-called LSD trips, followers of the equity cult seem to either have good trips (experiencing radiant colours and geometric patterns) or bad ones (when they panic feeling permanently severed from reality).

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Suddenly, after a seemingly unstoppable bull run over the past 39 months, investor sentiment is going through dramatic changes. Earlier, it was greed that fed their never-ending desire to buy stocks, with the abiding feeling being that scrip prices will keep on rising forever. Now, it's a mix of greed, and fears of an imminent correction that's forcing them to sell at the slightest uncertainty. Like the post-LSD haze, the investors' senses, emotions and awareness have been altered. It's either vivid fantasies or nightmares on a daily basis.

Dhirendra Kumar, CEO of Valueresearch, agrees, "Price has no sanctity anymore. There's no bottom for this market. It can be difficult to manage at 7000 points, but may be relatively easy at even 15000. The next 5-7 months will be difficult." Adds Manish Sonthalia of Motilal Oswal Securities, "We could be pretty close to the bottom of the fall. But if the situation continues like this, the markets could shed more."

So what exactly is happening out there on D-Street Global? Why are investors panicking one day, rebounding enthusiastically the next? Who's buying, and who's selling? And what does it really mean in the short run? Is this the beginning of the end of the ongoing bull run, or is it actually the end of the beginning of a new bullish trend? To understand this story, one will have to start in the US, hop across to Europe, make a stopover at Tokyo, before visiting the emerging markets in Asia and Latin America.

It really started with the crisis in subprime mortgages. Until a month or two ago, not many knew what subprime meant. Remember, not many knew about ready-forward deals in government securities till the Harshad Mehta scam was exposed in 1992. "I don't remember another word like this which a whole lot of stockmarket types had to learn so quickly about. And it's not even a real word," says Kumar. He adds that subprime has proved that the world of investors is actually a single family.

Several years ago, as liquidity, or cash in the system, increased, US lenders began giving home loans to people who didn't seem to be in a position to repay them. The borrowers didn't have to furnish any documents for these 'self-certified' loans; they had to only certify that they had the capacity to pay. One can ask why the banks would do this when it seems such a risky transaction? Why were the banks willing to lose money? Simply put, they had a safety valve that allowed them an easy exit route.

Using theoretical models, they bundled together several asset-based, say housing, loans into individual securities. Since the latter consisted of a mix of good and bad assets, they managed to get good ratings for the papers and, hence, higher returns than on American treasury securities. Realising the profits to be made, the rating agencies got into the game of advising banks on how best to bundle the assets to ensure high ratings. Then the banks sliced these bundles into pyramidical tranches, with the base consisting of the riskiest assets and slowly moving upwards towards the less risky and safer ones.

To cut down on their risks, the lenders sold the riskiest tranches to others. Since these pieces came with the highest returns—as the risk was greater—those driven by greed happily purchased them. Most of these were picked up at a discount by hedge funds, which seek higher risk-higher returns investment options. It was a win-win game. The banks took the least, or no, risks. As long as the housing sector was booming, the hedge funds knew their slices were backed by assets whose values were going up.

Similar securitisation happened in the case of other investments, like equities. Here the riskiest slices consisted of the money put in emerging markets, the top of pyramid were those invested in blue chips in the US or Europe. Yet again, the riskiest slices were purchased by hedge funds and other similar players. The logic being that the emerging markets story will continue, thanks to sound fundamentals. Large investment banks also got into this new paper games as they seemed almost risk-free and profitable.

At the same time, there was another trend that boosted inflows in global equities. For a long time, Japan's interest rates were low, almost zero per cent. Investors found it lucrative to borrow in Yen, and invest in emerging markets that yielded high returns. But then things changed as both the US and Japan central banks hiked their respective interest rates in a bid to cool down inflationary pressure in their economies. That suddenly changed the equation as Yen loans were no longer as attractive as before.

As this so-called unwinding of the Yen trade was happening, there was a slump in the US housing sector. In the beginning, the American lenders tried to boost demand by easing their loans even more. The borrowers were wooed with several incentives, including a freeze on their EMIs (estimated monthly instalments) for two years and no down payments. The subprime mortgage business did begin to look up, but real estate prices didn't. Then came the final expected blow: defaults by subprime borrowers.

Now, all the players were caught in a jam. Some of the hedge funds incurred major losses as the prices of assets comprising their tranches (of the combined loan securities) fell drastically. Shareholders asked the hedge funds to return their monies. The hedge funds had no option but to liquidate their profitable holdings, especially equities in emerging markets. As emerging market indices fell, there was an impact on equity-backed securities and tranches. More players were forced to sell their equities to cut their losses or pay back investors and shareholders.

Unexpectedly, theoretical models that indicated that the risks on specific tranches were like one in a million, or one in a billion, became outdated. The risks across securities and tranches increased manifold. In addition, all the players became scared as they were unable to sell the tranches, which had no buyers. No one really knew the extent of their respective losses since no one could determine the price of their asset-backed pieces of paper. There was general fear and loathing across all money markets.

As panic gripped lenders and investors alike, no one wanted to stay invested in anything, or invest in any fresh assets. Banks refused to lend to other banks leading to a liquidity squeeze. Central banks in the US and Europe did ease some of it by pumping more money into the system in mid-August. But that proved to be a short-term reprieve. Hedge funds were either packing up, closing shop, or simply returning the money back to investors. Individual investors just wanted out.

Meanwhile, volatility increased. Many who believed in the fundamentals in some markets did reinvest. That's why one saw pendulating market indices, both in the developed and developing nations. But fear became a bigger factor than greed. Apprehension became a greater force than optimism. The sentiments were clearly in the negative. Says Kumar, "I'll bet that a lot of Dalal Street types would like to personally lay their hands on an actual subprime borrower, grab him by the collar, give him a tight slap, and ask him why he bought a house he couldn't afford to pay for."

dds Sonthalia, "There is uncertainty over the full-blown impact on the subprime issue. It could lead to a lot of skeletons tumbling out of the cupboards of hedge funds andFIIs." He adds that after this crisis, hedge funds will be more fickle and it will take a few months for the dust to settle down. "We are in for volatile times ahead," he feels. Nagesh Kumar, director-general, Research and Information Systems for Developing Countries, agrees but adds, "This is just a temporary phenomenon."

The problem, says R. Chandrasekar of the Institute for Financial Management & Research, is that "while we may think that the Indian markets are not risky, overseas investors look at it as emerging markets having prospects, but carrying some risks. They may opt to move to the US market to park their money in instruments that carry less risk." Mandira Sarma of ICRIER feels that "any panic will lead to flight of hedge funds from one place, creating opportunities in other markets."

However, most economists and experts agree that the long-term implications for the Indian stockmarket are minimal. N.R. Bhanumurthy of the Institute of Economic Growth is one of them. He thinks that following the market turmoil in the short term, the US will reduce its interest rates which in turn will prompt India to follow suit. "This is expected to have a positive growth impact on the Indian economy, particularly when the inflation rate is within manageable limits," he explains.

The final words come from none other than Merrill Lynch. Its July survey among nearly 200 fund managers revealed that despite recent jitters in the global credit markets, institutional investors were "fully invested in equities". Michael Hartnett, their chief global emerging markets equity strategist, said that the survey proved that emerging markets had been able to shrug off the credit worries seen in the US subprime mortgage market. "Emerging markets continue to be in the midst of a substantial secular bull move." The shadow of the bears could vanish—fast.

But beware! Don't write the last chapter of this bull vs bear script yet. For no one really knows the extent of the problem, or the extent to which investor sentiment has been hurt. No one really knows how the story will pan out over the next few months. Way back in 2003, Warren Buffett, legendary icon for all investors, said that derivatives pose a "mega-catastrophic risk" to the US economy. As almost always, he was right. The subprime pyramidical tranches, if you will, are nothing more than a derivative of derivatives.