Jamal Mecklai: The nature of life

MARKET MANIAC

When growing up, I was often told, "Enough is enough", particularly if I'd been a bit more than usually rambunctious. Years later, when I had moved to the US, I was visiting an aunt, who shocked me one evening with the words, "Enough is too much." I could hardly believe it "" my aunt was usually quite cool, and this was the opposite; it was far too conservative for life, I thought. And then, one day, visiting New York I went into a bar "" the Lone Star Cafe "" which had a big banner that said, "Too much ain't enough!" That was more like it "" something I could live by!

Thinking on it now, it seems to me that these three mandates circumscribe the entire nature of life. A small number of people, driven by circumstance or, perhaps, by nature, are extremely conservative "" enough is too much; another small number, driven, I would guess, largely by nature, are risk-takers "" too much ain't enough; and the vast bulk of us are somewhere in the middle "" we overdo things sometimes, but generally live by enough is enough.

Of course, people do tend to move between groups, and when times are good [and/or interest rates (yields) are low], more and more people move towards the riskier edge of life (or the market), which gets overbalanced and ends up in wholesale collapse. This shift in risk appetite is exactly what happened over the past few years, which led, in a natural progression, to the sub-prime crisis and the collapse of confidence in the credit markets.

Going back a few years, the Fed, under Mr Greenspan, after first warning about "irrational exuberance" in the equity markets, watched as the technology bubble grew and grew and grew till it popped in 2000. The economy, which rapidly reversed direction from its "too much ain't enough" positioning, sank and in early 2001, the Fed started cutting rates. They kept at it till mid-2003, by which time the Fed funds rate was an almost invisible 1%. Rates stayed at this level for over a year, during which time bond yields also fell, with the 10-year hitting a low of 3.11%.

Investors everywhere began to look for some sort of meaningful return "" I mean, even if you live by "enough is too much", what can you do with a 3% return "" which led them to the eager arms of the growing band of hedge funds, who, dancing at the edge of "too much ain't enough", had been providing investors with much, much higher returns.

With flows into hedge funds increasing rapidly, and with alternative investment markets (commodities, emerging equities) too thin to take all of these flows, it was getting more and more difficult to find trading plays to generate these up market returns, which led to the phenomenon we all tasted over the past few years when there seemed to be investment money growing on trees.

Meanwhile, the US housing market was also rocking providing a continuous supply of mortgages, which were being packaged into a magical soup of securities. Securities (tranches of CDOs) with AAA ratings provided better than AAA yields, AA ratings gave better than AA yields; and high-risk, "equity" tranches paid much, much more "" sometimes up to 25%+, perfect for the hedge funds.

Even more magical was the fact that the composite cost of these structures was quite attractive, triggering huge demand for them from borrowers "" mostly private equity firms champing at the LBO bit. To keep feeding this demand, banks, investment banks "" the "too much ain't enough at all" set "" began to hysterically look for ways to create more paper. Lend, lend, lend to anyone, even if they can't spell their name. Sub-prime, Alt-A, zero down, do-you-know-who-you-are mortgages began to accelerate. As fast as the loans were made, they were packaged as security (ha ha) for more and more borrowings, private equity deals got larger and larger, equity markets rose in delighted sympathy, and LVMH and other purveyors of luxury goods made out like bandits as the financial sector made and spent billions.

All of this furious economic activity, of course, ignited the fear of that old sleeping giant "" inflation. The Fed started raising rates gingerly in 2004. But, the market was just coming into its own. Sub-prime (and other risky) mortgages grew like topsy, US economic growth rocked and equity markets took to the skies. The Fed, huffing and puffing, kept pushing rates up, first under Greenspan and then, Bernanke, till finally, around the end of 2006, the higher rates began to bite. And, of course, they bit most viciously at the highly leveraged poorly documented high-risk mortgages. And, as these started to default, it started a chain reaction that reached as far as Europe, Australia and even China, ending in a major credibility-driven credit squeeze.

In the larger context, this is hardly surprising "" if too many people play for too long at the "too much ain't enough" edge, it will give way, after which there will be a rush away from risk. Sure enough, US Treasuries have been soaring with short-term yields falling (for a bit) below 3%. It is hard to estimate how long this period of risk-aversion will last. The US government has got into the act and all eyes remain sharply focused on the Fed. In any event, when the dust settles, there will be lawsuits against mortgage lenders, rating agencies, investment banks, hedge funds, the works. The lawyers, as usual, will have a field day. And the show will go on.

On a closing note, it is important to recognise that the "too much ain't enough" crowd is always disproportionately young. Given that India has a huge percentage of young people, it seems clear that over the next few decades, India's risk appetite will rise sharply; expect younger politicians and bureaucrats, stronger growth (probably 12+), and a much better life for us all.