'Cheque De' India!

SMARTSHARE

A few months ago ("Fundamentals are deteriorating", March 17, 2007) we had mentioned the looming trouble in the housing market. The following is an extract from the column.

"...13.33 per cent of all sub-prime loans were in default, the highest level in five years, and foreclosures were the highest in 37 years. Housing prices could fall, following more foreclosures, which in turn could send prices still lower, which in turn would mean more defaults and the cycle goes on. Rising inflation and the need to attract foreign exchange may not allow the Fed to cut interest rates, which would make matters worse."

That housing ducks will come home to roost was never in doubt. My prognosis at that time was that more foreclosures would mean that the American consumer, who has used his home as an ATM in the era of rising housing prices, would suddenly stop buying, which will derail the US economy, as two-thirds of the US GDP is accounted for by retail consumption.

But it is the buyers of these securities that have blinked first. The first casualties were, of course, hedge funds. As most hedge funds are highly leveraged, small losses can get magnified several times over.

Long-term assets and real estate have been financed by hedge funds with short-term debt instruments, and the amount of the debt now exceeds the value of the collateral in these sub-prime investments. Somebody will have to pay for this difference.

As the price of such assets fall, all those who are holding similar assets have to worry. As one hedge fund collapses, investors can withdraw money in anticipation from another. Such withdrawals can create problems for a fund, if none existed before. This has a cascading effect and a small problem snowballs into a major issue.

The roots of the current problem lie in the Greenspan era, when rates were slashed from 6 per cent to 1 per cent (2000 to 2003) and housing picked up in a big way. Once those loans were made, the banks started bundling up a collection of mortgages into an Asset Backed Security (ABS) and selling it to the secondary mortgage market.

People selling the mortgages didn't have to worry about ever getting paid back because someone else was buying those mortgages and taking on the risk. So you had a scenario when the only pre-requisite for a housing loan, as a wag puts it, was to have a pulse.

The main problem is that no one knows the quantum. Assurances by hedge funds that there are no issues with them need to be taken with a dishful and not a mere pinch of salt. It's a market where most players are either unaware or just lying.

The second problem is that for a large portion of the sub-prime loans that were made in 2006, the rates are yet to be reset higher. Once that happens, you could see more funds going belly-up sometime early next year.

Coming back to our own markets, on Thursday, when this piece was written, the Sensex had fallen 642 points and the advance decline ratio was still 8:18 stocks on the BSE. We have never seen so many stocks up, on a day that has seen so much blood on the street. Stocks that hit the upper circuit were 315 as compared to 123 that hit the lower circuit. This is astonishing. Was it a one-day wonder?

Not really. If you take a roll call of indices, you would find that the Sensex has fallen 8.09 from its high, the BSE Mid-Cap has fallen 5.76 per cent and the BSE Small Cap just 3.56 per cent from July 24 highs. One possible reason of this relative strength of the small caps is that as FIIs don't own them, there is no selling pressure.

But if the global markets continue to roil, these small caps too could wilt. The

Yen carry trade unwinding is walloping the metals. And the sub-prime menace is spreading to the normally immune commercial paper.

As the markets enter the oversold space, they could rise any day. But that may be an opportunity to lighten commitments. For the moment, with due apologies to Shah Rukh, the US markets are saying:
"Cheque De" India.