Speculating Fear

There are all sorts of reasons over what caused the crash last week, but real question is how can the market go, on a random Thursday afternoon, completely insane? Everyone is looking for someone to blame. But what made the crash on May 6th so absolutely shocking is the market dropped close to 1000 points in a few minutes… I mean in a few MINUTES!!!! Between 2 p.m. and 3 p.m. the Dow lost over 900 points before dramatically bouncing back about 600 points.

One thing is for sure, as the trading volume soared, data systems across the stock market began to get clogged. By 2:37 p.m., the overload seemed to have taken its toll on the NYSE's ARCA electronic-trading system. The bid/ask prices got out of control and the price of stocks were going insane. Accenture went from trading at around 40 dollars a share all the way down to one cent before bouncing back. Nasdaq detected what it felt was questionable information in the data and sent out a message saying it would no longer route quotes to ARCA. This step—known as declaring "self-help"—doesn't happen often among the major exchanges. By evening however, all exchanges in a rare coordinated manner put out a statement saying "All trades executed between 2:40 PM and 3:00 PM that increased more than 60% or decreased more than 60% away from the consolidated last print in that security at 2:40 or immediately prior" will be cancelled." Obviously this decision will not be open to appeal but while Nasdaq and others canceled trades on more than 200 largely NYSE-listed companies whose shares fell or rose more than 60 percent, investors unlucky enough to have sold depressed shares of other companies that fell less have little recourse and those who made money by buying at the bottom and made less than 60% can rejoice at others expense. Exchanges have never been blamed for losses, but my guess is this will be tested in courts this time around.

So far, a lot of people have been blamed. But even after a couple of days, there is no real rational explanation as to what went really wrong and caused the drop. There are theories, but no real answers yet!!

So what are the theories circling around?

• Fat Finger Issue - It has been widely suggested that a "fat finger trade" was responsible for triggering the panic. A trader entered a "b" for billion instead of an "m" for million in a trade involving Procter & Gamble. No confirmation yet but after a few days, this explanation possibly looks untrue
• Computer Glitch - There were many erroneous trades due to bad pricing, but the systems of course do not know that and did one thing lead to another and the systems get out of control?? Anybody’s guess at this point
• Stop Orders - There were 1000's of stop orders which got triggered due to the market breaking certain levels. Did a series of stop loss orders trigger a downward spiral maybe?
• European Debt Crisis - Greece definitely contributed to markets going down, but it is unlikely to be the sole cause that led to the all out assault on the markets
• Just plain Fear and Panic - There is also the possibility that this was a real financial panic. There are huge concerns about what is going on in general with the debt levels and the currency markets are fluctuating wildly. The Dow was already down several hundred points even before the massive plunge took place. The reality is that there is a lot of fear in the financial markets right now. But if it was a real panic, then why did the Dow bounce back so quickly?
• HTF - More than 60% of today’s trading is done electronically, so could High Frequency trading have been the cause for what happened? But if it was just high-frequency traders bailing out, why wouldn't [that drop] happen on every stock? It just doesn't add up.
• Hacking - Implausible without proof, but possible. It does sound farfetched, but hey, till now the exchanges have never been held responsible for the losses. So did someone hack into NYSE and purposefully create this mayhem not to mention walking away will a ton of money and a big smile as others are scrambling around to understand what went on.

As more details of last Thursday's collapse become clear, the picture is one of a highly rare confluence of events, some linked, some unrelated, that exposed weaknesses in the stock market large and small. But the only interesting thing here is the catalyst that stopped the fall. Whatever caused the market to crash stopped after a point which led to the reversal. So what was the catalyst?? I doubt anyone can really get to the bottom of this for a long time to come.

Interesting - Market Stats!!

There has been a lot of talk regarding the performance of the Dow Jones (DJIA) so far during Obama's term. Many said that his election would bring about a new sense of hope in the American psyche...I guess the markets disagreed.

Through yesterday's close, the DJIA's performance during President Obama's first 41 days in office is the worst of any President since at least 1900.

Where Will It End?

I got an interesting email from my sister this morning and she could not have summed up the pain and frustration everyone is feeling any better. So with her permission, I am putting up her email on my blog. So here goes.....

Are'nt we all getting tired of this recession? Yeah yeah there are a bunch of you out there who are still in denial about the country being in recession, but whatever you'd like to call it, are'nt we just beat, bored, broken down, burned out, distressed, drained, exhausted, fed up, pooped, worn out and just dog-tired of what’s going on? Yes the down turn is in its peak, yes the government has no money, yes people are losing their jobs and yes we're scared to spend in the fear of losing our jobs. 2008 saw the fall of the bank and 2009 is going to see how this translates into core industry. A couple of weeks back there was a surge of hope when the American folk went and voted for the the golden boy .... but the stock market has accomplished stripping us of all traces of elevated spirits after that.

The DOW closed under 8000 yesterday and while it sounds about right, there’s a part of me that wants the DOW to plummet to its lowest ....TODAY! At least we can move on after that. But the other part of me knows that we can’t drop too fast either. We need to feel every pang of misery, slowly and painfully, so that we rid ourselves of all our sins and make for a fresh start.

The dot com bust and the govt surplus during the Clinton administration was reason enough for the recession to set in (its a zero sum game people - surplus with the govt means no money circulating amongst the public - well more or less), but that recession was one that should have been worse than it was. The super hero of the moment was Alan - Visionary - Greenspan. When Clinton shouted 'Affordable Homes for all Americans' Greenspan should have stepped down and let the monkey run the Fed in the hope of a random lucky move that monkey might have made. Instead he sealed the fate of the economy with his monetary policies. Affordable homes indeed.... all for about 2 seconds.. then they became unaffordable again when the 'visionary' raised interest rates and forced the American to default. Lets not forget the banks.. now now how could we forget the greed that this industry so beautifully camouflages into helpful stances for all common man! You're worried about Wall Street - HA! Main Street feeds Wall Street's avarice!!

So where are we now? The American man cant pay back his home loan - so banks don’t have any money - so corporations cant borrow money - so corporations cant start new projects - so corporations have to let go of workers - so workers cant pay their mortgages... what a cycle!.. and once started we cant stop the downward spiral. And not to forget the derivative markets that have exploited every single portion of this cycle. Now with everything failing, is there a floor? We thought banks might see their write-off floors when the government proposed the buying of troubled assets. Banks could sell their troubled assets for eg. 40 cents on the dollar (whatever the amount - we don’t know) and they would not have to write off more than the left over 60 cents. Banks would rake in the 40 cents as capital and life was supposed to move forward. The $700B bill struggled initially but finally went through both the Senate and the House and Henry Paulson took possession of the first $350B to start his clean up work... We've seen the stock markets rally and spiral a few times since then and we've also seen the new president-elect create waves.. but we haven’t seen the buying of troubled assets. From his statements, it seems like Hank's changed his mind. Bank stocks are plunging again and we have no idea what the floor is. Whatever it turns out to be, lets hope we don’t see it higher or sooner than it should be. From the policies during the last recession, Greenspan created a huger monster that is the down turn now.. With all the bailouts and the bandaging and caretaking the Feds are doing, lets hope we're not creating an even bigger mess.

Mark-To-Market - Hero or Villain?

The financial markets are getting clobbered everyday to a point where it makes no sense anymore. It is not a question of 'Will', but 'When' the next write down is coming. If it not really ‘If’ but ‘Who’ will be the next bank to fail. One of the biggest problems is being blamed on the "Mark-to-Market" accounting rule. Mark-To-Market (MTM) accounting rules have turned a large problem into an ever larger one. MTM also known populary as ‘Fair Value’ accounting is facing opposition now from all quarters as it is forcing financial firms to treat all potential losses as if they were actual cash losses. i.e. this rule assumes that what people are willing to pay for an asset is always the same as the asset's value. This means that companies must value the assets on their balance sheets based on the latest market indicators of the price that those assets could be sold for immediately (read today). Under such a rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them is worth less. For e.g. lets say the mortgage was sold at X today. But when the value of the house reduces (especially now with the credit markets frozen up) and someone is only willing to pay X-5 for the same mortgage today, the rule says the firm must immediately write down a loss of 5 as the mortgage can be sold for X-5 today.

Its a tough rule since there is no market to establish the real value and not all assets that have no trading market are bad assets. Moreover, the firms do not have to sell them today itself, so does it make sense that they really have to value them at the prices they fetch today? Even if the firm does not sell at the low price, and even if the value of these assets is above the price at which others are willing to pay today, the firm must record them as losses on the books - the sole reason which is causing write down after write-down, thereby violating capital requirements causing the equity to tank and in turn the stock prices to fall. Once panic sets in, we have seen what can occur with Bear, Lehman and ML - people simply start panic selling, even when they know the underlying business of the company is fine. It looks like a vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent are bring forced to price assets at fire-sale values chasing away capital and leading to a further decline in asset values. All the banks have taken a hit because of this rule.

Further confusing investors, the rule has inconsistent application across industries and companies. MTM favors private companies over public companies. As the government is being so aggressive with the use of these capital regulations with the banks, we can see just about the only transactions taking place in the sub prime marketplace have been sales to private equity firms that do not have to mark assets to market prices.

Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting write-down. The same is true of what happened to Fannie Mae and Freddie Mac, which had positive cash flow when they were nationalized by the Treasury. Here's something you won't believe: Fannie Mae and Freddie Mac have not drawn a dime from the Treasury's $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt. On a cash flow basis, they were solvent.

Because of all this, Washington finds itself in a somewhat awkward position in that its own rules is rendering many financial institutions insolvent in a manner which does not reflect their true value. A lot of big banks (Actually all of them) are currently lobbying heavily in Washington to get rid of the MTM accounting rule. But I think a mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic write downs, banks might be more willing to lend, raising home prices and reducing foreclosures. The economy might just jumpstart but at this point my guess is as good as yours and the truth is no one knows how things are going to play out.

The $700 Billion Dollar Question

The stakes are clearly huge in the Treasury's proposal to stabilize the US financial system. It looks like the treasury secretary, Paulson, has become even more powerful now with $700 billion at his disposal. I think the plan which promises to buy up to $700 billion of a variety of troubled assets (read mortgage-related securities and loans) will at least enable financial institutions to restructure and recapitalize their balance sheets. But while Wall Street may be bailed out, i still question the impact to Main Street. But a lot of critical answers seem murky or unanswered like what the real prices for these distressed assets are or how these assets will be valued. Also, who is going to manage them and is the government really going to hold them till maturity like it claims to.

The participating financial institutions can dispose of their troubled loans and securities closer to their intrinsic value..this means that all the problem assets will be flushed out and the banks can resume getting back to normalcy. This would go a long way to restore confidence since there won’t be any 'write- downs or losses' every quarter.

Here are some questions for which I think we need some real answers.

How will prices be determined? - This will totally make or break the success of the bailout. With all the write downs as any indications, setting the purchase price is not an easy task. The pricing at which Treasury buys the assets will likely become the benchmark pricing for all mortgage assets.

How will banks decide whether to participate in the Treasury program? - This is weird as participation in the Treasury asset sale program is voluntary. Banks can keep mortgage assets if they consider Treasury asking prices out of line with intrinsic values, taking into consideration ultimate losses from defaults. Again, goes back to the previous question, if prices are not set correctly, banks simply won’t participate.

What will be the impact of such sales to capital base? - This is kind of a double jepordy as the impact on financial institutions' capital will depend on the price levels at which the Treasury makes its purchases. Even if the firms choose not to participate or sell assets into the program may also need to mark down assets based on newly established benchmark prices, leading to erosion of their capital....there by coming out with more 'write-downs'

Is $700 billion enough? - This is the golden one. $700 billion is a lot of money. It is much greater than the $85 billion loan to AIG plus another $38 billion they are giving AIG (just announced today), and the $100 billion of capital support to Fannie Mae and Freddie Mac or the $29 billion to JPMorgan deal for Bear Stearns.

This bailout seems like an extraordinary governmental intervention - although it will provide important short-term relief, does not look like a complete solution to the financial markets. Again make no mistake; the plan will help the banks. I don’t see how the common man is going to be really benefited. To think that the ex-chairman of Goldman will be handing out $700 billion to other wall street banks... It just seems like wall street's his inner circle will benefit from all of this even more... Just barely was the plan announced and he already tapped his favorite banker from Goldman to be his adviser. I just question why the taxpayers money is being used to make wall street CEO's more rich and help them get bigger tax breaks.

Around The World...Banning Short Sales

It is amazing how much controversy there is surrounding the ban on short sales. While the decision has drawn relief from some quarters, let there by no doubt that there are quite a few people who are unhappy with SEC's decision. While UK took the first step to ban short sales and added pressure on other markets to respond, the US followed suit shortly. And now it looks like the entire world is jumping on the bandwagon with Australia, Taiwan, Netherlands and Germany also confirming the ban of short sales in their respective exchanges.

I suspect that the ban was done to appease the common investor who has probably been wiped out in the ongoing financial tsunami and as the politicians realized they have to do something to make themselves look good. The Fed and SEC have clearly indicated with this decision, that they are and will go to any lengths to preserve the US financial system collapse including changing the rules midway through the game, with no public comment or participation if required. Note that the ban on short sales does not mean that stocks will only go up. China's market has fallen by more than 50% this year alone even though short selling is not allowed at all.

By banning short selling world over, it looks like what the governments are clearly worried about is the fine line between "freedom" and "manipulation". I personally think that there is nothing wrong with borrowing stock to short, but given the sensitiveness in the global market, the worry is that even a small/negative sentiment can cause a big shift in markets which in turn can cause greater panic worldwide. Note that there can be 2 kinds of short selling. Normal short selling occurs when investors borrow shares and sell them, hoping the stock will fall and they can buy back the shares at a lower price. Naked short selling occurs when an investor sells a stock without first borrowing the shares, and that practice allows investors to flood the market with sell orders, potentially driving down share prices.

Why the ban maybe difficult to enforce

• First off, this is only a temporary ban. Let’s wait and watch if the ban is made permanent. If it is, it will significantly change the rules of the game
• Over the past few years the options market has grown to reach the ordinary investor. There is nothing that short selling provides which cannot be done through put options, albeit at slightly higher cost, due to the options premiums and the bid/ask price spread.
• Volumes in credit-default swaps and other derivatives trades and options are likely to rise in the wake of the short-sale restrictions - This is likely to cause a bigger headache as these complex derivatives are not subject to full disclosure and they are not publicly traded
• This will cause the traders to start focusing on non-financial stocks which can still be shorted via ETF's etc.
• Hedge Funds will be unable to hedge large positions and will likely take some hits. (Not sure what the impact will be to the broader markets once hedge funds start to fail)

Disclose Positions?
Apparently just banning short sales was not enough. After the announcement, pressure mounted for the SEC to do even more as its counterpart in London increased its regulatory responses. By evening the SEC came up with a new surprise – It required investment managers to publicly report their short positions weekly. Though I believe the SEC has every right to obtain and review information about short positions for market surveillance purposes, but forcing public disclosure will have serious consequences for the market. Companies will most definitely retaliate against short sellers. Portfolio and fund managers will lose their ability to manage assets without revealing their strategy. Once someone is short selling a security, other traders will simply do the same thing adding more pressure and this may trigger panicky selling if an investor sees that noted short sellers have shorted the stock.

These are extraordinary times and agreed that we need to support the govt’s efforts to ensure that fraud and manipulation have no place in this market. But the confusion and scapegoating that has ensued may well do more harm than good. Short selling or even naked short selling cannot destroy a company that has any real underlying value to it. Bear, Lehman and the other financials didn’t getting pounded because of short selling. They got pounded because the leverage game was over. I think because of the temporary ban, there is going to be a big rally - albeit an artificial one - which will end by still not revealing the true intrinsic value of the stocks.

And Then There Were None

As the Fed is rushing to pass the 700 billion bailout in Congress, the last remaining 2 investment banks Goldman Sachs and Morgan Stanley have been transformed into bank holding companies. This completes the decimation of the good old investment banking model and re-writes wall street as we know it.

Well, what this mean for Goldman and Morgan - they will be able to begin taking deposits like traditional banks which will increase their cash balances. In return they will be subject to far greater regulations and look more like commercial banks. They will also need to hold higher capital reserves and take less risks. And in return to subjecting themselves to more regulation, they will get full access to the Fed's lending facilities and discount windows which should help them avoid a Lehman like situation.

As bank holding companies, the two banks will have to reduce the amount of money they can borrow relative to their capital. That will make them more financially sound but will also significantly limit their profits. They are both highly leveraged compared to traditional banks. Today, Goldman Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. This will have to come down for both. By contrast, Bank of America's has less than $11 for every $1 of capital.

So, now that the stocks of GS and MS will trade like banks, are they really worth $130 and $27, respectively? I doubt it. But we might not know what the market really thinks about all this until the ban on short-selling is lifted.

Here we go..From 5 to 2 in 6 months!!

A perfect Storm.. Return of the Black Monday...Wall Street Hurricane.. Financial Tsunami..

These are some of the terms that are being coined to describe the unprecedented chain of events that have occurred over the last 24 hours. Lehman Brothers has collapsed and Merrill Lynch has agreed to be taken over by Bank of America. The events of Sunday September 14th and the day before were extraordinary. The weekend began with hopes that a deal could be struck to save Lehman. However, as the weekend progressed, it looks like the fed drew a line in the sand citing moral hazard and BOA and Barclays balked at the idea of having to takeover Lehman with no Fed backstops.

Around Sunday evening the chatter began that Lehman would not survive and late Sunday came the stunning news on the Lehman website that it had filed for Chapter 11. Though founded in 1800's, Lehman is not 158 years old as many people believe. Lehman is a 14 year old investment bank with a 158 year old name. Though the bank has access to a Fed lending facility which was introduced after Bear’s takeover by JP Morgan Chase, the collapse of its share price left it unable to raise new equity. At the end of August, Lehman had $600 billion of assets financed with just $30 billion of equity. Even a 5% decline in assets would wipe out the value of the company, which investors saw as a real risk due to the company's billions of dollars of mortgage securities. S&P lowered its long-term counterparty credit rating on Lehman to 'SD' (selective default, meaning payments may not be made on some financial obligations), from 'A'. The rating actions followed Lehman Brothers Holdings Inc., the parent/holding company of the Lehman Brothers group, filing for Chapter 11. At this time, it is not clear whether Lehman will default on its holding company senior and subordinated debt obligations. It is also uncertain whether the proceedings will ultimately include some of Lehman's affiliates in the U.S. and in other countries or whether regulators will take over those entities. Where bankruptcy protection leaves Lehman employees remains unclear. Although some are thought likely to pack their stuff up and ship out Monday, the fact is that the broker-dealer and investment management units are not included in the filing. Lehman has also filed motions to continue paying its employees in the meantime, though large scale layoff's are expected anytime.

The government's refusal to help with a bail-out of Lehman will strip many firms of the benefit of being thought too big to fail and with these developments the crisis is entering a new and extremely dangerous phase. The biggest worry now is the effect on derivatives markets particularly the credit-default swaps. Lehman is a top-ten counterparty in CDSs and holds contracts with a notional value of almost $800 billion. With Lehman left dangling, official attention is now turning to putting more safeguards in place to soften the coming shock to markets and the economy. The first step has been to encourage Lehman’s counterparties to get together and try to net out as many contracts as possible. It also has over 100,000 creditors. The inability to find a buyer is a huge blow to Lehman’s 25,000 employees, who own a third of the company’s now-worthless stock; On Sunday the Fed also expanded the list of collateral it will accept for loans at its discount window, to include even equities; and dealers may lend any investment-grade security, not just triple-A rated, to the Fed in exchange for Treasury bonds.

Merrill’s rush to sell itself was motivated by fear that it might be next to be caught in the stampede. Despite selling a most of its rotten assets recently, the market continued to question its viability. Its shares fell by 36% last week, and hedge funds had started to move their business elsewhere. John Thain went right ahead and struck a deal before markets reopened. Despite what people say, I think it’s a smart move as Mr Thain has not only managed to shelter his firm from the storm but he has also secured a price well above its closing price last Friday, $29 per share compared with $17 close. How he managed that in such an ugly market is not yet clear. Ken Lewis, BofA’s boss, is no fan of investment banking after he was stung by losses and openly declared he is pulling back. Having failed to build his own investment banking unit, he coveted Merrill’s formidable retail brokerage and got it all. It will be a logistical challenge all the more so since BofA is in the middle of digesting Countrywide, a big mortgage lender. Commercial-bank takeovers of investment banks have a horrible history because of the stark cultural differences. And it is not clear if BofA has a clear picture of Merrill’s remaining troubled assets.

The takeover of Merrill leaves just two large independent investment banks in America, Morgan Stanley and Goldman Sachs. Both seem to be in better shape but this weekend’s events has undoubtedly cast a shadow over the standalone model.

Even if markets can be stabilized this week, the pain is far from over—and could yet spread. The foreign markets are in the red and the Dow has crashed more than 500 points as I write this – its worst performance in 7 years. Worldwide credit-related losses by financial institutions now top $500 billion, of which only $350 billion of equity has been replenished. This $150 billion gap, leveraged 14.5 times (the average gearing for the industry), translates to a $2 trillion reduction in liquidity. Hence the severe shortage of credit and predictions of worse to come.

As spectacular as this weekend was, more drama is on the way as a Category 5 hurricane is testing the strength of the Financial levees.

Talking about Inflation!!

The Indian people and the government are both quaking with fear with inflation hovering at around 8%. The people can barely make two ends meet with prices soaring, and the government knows that if prices don't fall, the government will.

But India is not the only nation grappling with rising inflation. Even people from wealthy countries are crying everyday over ever increasing prices of bread and vegetables. However, they can all thank their lucky stars cause they are sitting pretty compared to Zimbabwe.

Do you guys want to even guess the inflation rate in Zimbabwe??

355,000%!

No, it is not a typo. The inflation in Zimbabwe for the month of March/April 2008 rose to 355,000%! Yes, 355,000 per cent! It more than doubled from the February/March figure of 165,000%. Currency traders ceased operations last week on Thursday and Friday because of the free fall of the ZWD and annual inflation certainly exceeded 2 million percent.

It is indeed a miracle that the Zimbabwean economy is still surviving as the prices seem to be rising to unprecedented proportions. Inflation surged between February and March following the sudden rise in money supply that flooded the economy to finance the 2008 elections.

The economy is in real free fall right now as inflation accelerates rapidly making life almost unbearable. It is predicted that by the end of the month, prices could be doubling everyday. Almost 80% of the nation is unemployed. The Zimbabwean central bank has introduced $500 million bearer cheques (or currency notes) for the public, and $5 billion, $25 billion, $50 billion agro-cheques for farmers. As the consequence of this devaluation, huge anomalies are developing in the system and prices, charges, service fees, etc can be dramatically lower than the next simply because the organizations have not had time to adjust their costings or figures.

Mr. Mugabe has certainly upped the ante by coming out and publicly saying he will not give up power even if he loses. He has openly promised 'War' if the opposition wins. That indeed poses serious questions as to weather the economy can be contained anytime soon. A sausage sandwich sells for Zimbabwean $50 million and a 15-kg bag of potatoes cost Zimbabwean $260 million.

Phew!!!

The Shrinking Economy

The U.S. economic data seems to be coming in much stronger than expected. Real GDP rose 3.9% in the second quarter and payrolls jumped 166,000 in October. Does this mean the economy is ignoring the housing problems and energy prices, or does it just mean that the eventual decline will be even worse?

The Federal Reserve's quarter-point interest rate cut on Oct. 31 suggests that they believe the worst is yet to come. Whether the economy is moving towards a slowdown or turns into a recession depends on three factors:

• Can consumers continue to ignore energy and home prices?
• Will the current problems in financial markets extend the downturn beyond housing into other sectors, especially commercial construction?
• Will overseas economies continue to grow and buy more U.S. goods?

The higher oil price does raise the probability of recession. Three consecutive quarters of growth near or less than 1.5% mean that a negative quarter is very likely but lets hope with luck there won't be two in a row.

SPENDING SPREE

The ability of the American consumer to keep on spending continues to surprise pretty much one and all. Consumer spending again rose at a 3.0% annual rate in the third quarter, rebounding from a slow 1.4% in the second quarter. The saving rate rose to 0.9% in September. So far, however, it is clear that consumers have no doubt been living up to—if not beyond—their incomes.

Even more important is the rise in oil prices, which is squeezing consumer buying power. Oil hit $97/barrel on Nov. 6. It is widely being forecasted that the price will retreat to $85/barrel over the next few months. Although the underlying supply and demand conditions suggest that prices should be lower, worries about the middle east, problems between Turkey and the Iraqi Kurds, with President Musharraf in Pakistan, and with Iran all add to fears of supply disruption
The risk of further price hikes is clearly very real, and these could further squeeze consumers.
It is expected to slow, but not stop consumer spending.

GLOBAL EFFECT

The major area of strength for the U.S. economy is foreign trade. The widening trade gap had been a drag on GDP over the last several years, but it has been improving since last January. U.S. growth has slowed, slowing imports, while growth overseas has remained stronger. The falling dollar has also helped boost exports. Over the last four quarters, the improvement in the real trade deficit has added 0.75% to real GDP, accounting for 30% of the 2.6% real GDP growth.
Asian growth appears solid. Chinese GDP is set to climb 11.5% this year, with Indian real GDP set to touch 9.5%. Some slowdown in both is likely next year, but China's should remain in the double digits. The developed countries are doing less well. Europe is slowing, in part because the strength of the euro hurts exports and U.S. growth is slower. Japan's real GDP fell in the second quarter but should rebound in the third. One advantage for the rest of the world is that the U.S. slowdown has been concentrated in residential construction. Because residential construction has a relatively small import component, the effect on exports from Asia and other markets has been much less than if it had been concentrated elsewhere.

There has been a lot of talk about the decoupling of the world economy. That metaphor is incorrect. The world is more tightly coupled than it has ever been by financial and trade flows. The difference is not that the train has come uncoupled but that the train has more engines pulling it. A decade ago, the U.S. was 23% of world GDP in terms of purchasing power and accounted for about the same percentage of world growth. Today, the U.S.'s share of world GDP has shrunk to 20%, and it accounted for only 12% of 2006 growth. China, in contrast, has risen to 15% of world GDP and 30% of world growth.

Oil prices are a problem for other countries besides the U.S., but there is a critical difference between a rise in oil prices caused by stronger demand and higher oil prices caused by supply disruption. When demand pulls oil prices, the higher costs to the oil importers are balanced by higher income for oil exporters, who either spend the money or invest it. This recycling of petroleum revenues helps keep the world economy going despite higher costs. It is not a perfect balance, and it has contributed to the problems of excess liquidity that has inflated bubbles around the world, but it is better than the alternative.

The dollar is of course going to continue to fall. The current account deficit, although it has shrunk, remains very wide at 5.5% of GDP in the third quarter. In the last two years, the inflow of capital seeking higher yields in the U.S. offset this. But a year ago, U.S. Treasuries were trading a percentage point higher than equivalent European government bonds. Today, that spread has shrunk to only 15 basis points (bps). In addition, foreign investors are worried about the dollar decline, making European investments look like a better bet. August was the first significant outflow from the U.S. financial markets in over five years; it will continue.

Fed’s work is cut out

The Federal Reserve has cut interest rates twice already, by a total of 75 bps. The Fed statement was tough, but no one is denying the weakness in the economy and it is likely to force another rate cut, most likely early next year. The Fed is right to be concerned about inflation, especially given the falling dollar and its impact on consumer prices. But in the short run, recession is the bigger risk. Even if there were no election in 2008, the Fed would have to focus on real growth—at least for a few quarters.

The Politics of Economic Policies

India has had an unprecedented stretch of growth over the last four years, averaging over 8% per year. Inflation was relatively low in the early part of this period but has picked up recently, thanks to demand-side pressures. RBI began a monetary tightening cycle in late 2004 and has maintained this stance in its quarterly announcements. However since 2006 — along with increases in its benchmark rates, the bank has been using the cash reserve ratio as an additional instrument to control surging liquidity. This liquidity can be mainly attributed to high capital inflows, which have risen significantly over the past few quarters and are flowing into equity, corporate debt, and remittances from NRI’s (which seem quite unstoppable now).

By 2007, RBI has abandoned its currency management regime, which had resisted appreciation. The bank is now allowing the Indian rupee (INR) to more accurately reflect the balance of payments surplus. The currency has responded sharply to this tactic, appreciating by almost 10% over the last three months.

Growth, Despite Rising Interest Rates
As the Chart indicates below, the economy grew at 9.4% in fiscal 2006-2007 (April-March), spurred by a steady acceleration in the manufacturing sector. Industrial production grew at a double-digit pace over the last few quarters, a pattern that is inconsistent with the steady increase in benchmark interest rates over the same period. In fact, much of the growth momentum was provided by sectors such as construction and automobiles, which are recognized to be relatively sensitive to interest rates. This indicates the ineffectiveness of tightening monetary policy, which depended entirely on hiking interest rates. The banking system was able to offset the central bank's rate increases with the huge increases in liquidity from high capital inflows. Only when the bank implemented direct measures—the cash reserve ratio—to rein in liquidity in late 2006 did lending rates begin to increase.

The impact of these recent moves is only just beginning to become visible. Industrial production numbers for the initial months of the current fiscal year (April 2007-March 2008), while still showing high growth in the aggregate, clearly point to a slowdown in some critical sectors—automobiles and metal products, in particular. It also reflects long-term optimism about business conditions, even as the immediate future looks a little less bright than in 2006-2007. Meanwhile, the services sector, the largest and fastest growing segment of GDP, shows every sign of maintaining its momentum.

Yes - Export Growth is Slowing

The Chart below displays the rather dramatic impact on export growth (in rupee terms) as a result of the rupee's sharp appreciation over the past few months. This rate of growth is relevant in measuring the top-line impact of appreciation on exporters. Of course, businesses dependent upon imported material clearly benefit from this development, but the combined impact on exporters and domestic producers of importable goods is likely to significantly reduce aggregate demand, thereby contributing to the soft landing.

The reason the central bank abandoned its protection of an undervalued exchange rate was that it was becoming impossible to offset the expansion of money supply that resulted from foreign exchange reserve accumulation. The RBI realized that it cannot buy $$ at the same pace that $$ was flowing into the country. The impact of an appreciated rupee will no doubt linger for some time to come, while exporting and import-substituting businesses are forced to take immediate actions to improve productivity. Short of a massive crash in the equity markets that provokes a sustained exit of foreign investors, the rupee is unlikely to depreciate from current levels. The only question is whether it will have an unrestricted rise or if RBI will step in to attempt a more gradual and stable appreciation.

Time to Relax??

Based on the current dynamics of the Indian economy, GDP growth during 2007-2008 will drop from last year's 9.4% to around 8.5%. Given the likelihood of a neutral monetary stance over the next few quarters, growth during fiscal 2008-2009 should accelerate somewhat to the 8.5%-9% range. There is always a risk in the form of market turbulence and rising oil prices, both of which could prove to be destabilizing. At this point, however, their significance is not great enough to offset the strong fundamentals underlying the recent surge in growth.

There should be no surprises in inflation and it is also likely to hover around 5% during 2007-2008. Pressure on the rupee to appreciate continues under this scenario, as capital inflows more than offset a potential current account deficit. The risk here is from global market turbulence, which if severe enough, could even reverse the trend in the rupee. If this risk does not materialize, the rupee will appreciate in a managed way and everyone should be prepared for the Rupee to stay at the 39-40/1 mark with the $$ for a long time to come

Fed: To-Do or Not-To-Do

The US Economy has a Cold...So What???

So the million $$ question is ‘What is the Fed going to do?’ Are they going to lower interest rates or keep them steady?? Are they going to sit back and let billions be shaved off or are they going to try and control the financial markets. Anyone who has been watching their investments, the stock market and major indexes must be having a panic attack right about now. As the weather has heated up in the summer, the economy seems to have cooled.

Problems in the credit markets are translating into fears for consumer spending as well as increased worries about housing. All headlines keep talking about subprime and credit fears. So the bigger question is ‘Is there a real reason to be worried??’ If so, when should we start to worry or has that train already passed. Lets see, the 3% growth rate of the past four years has slowed to 1.9% over the last four quarters.

The economic weakness also changes the outlook for interest rates. Both the European Central Bank (ECB) and the Federal Reserve (Fed) have added reserves last week, with the ECB doing most of the work.

So, What’s up with the Housing Market?

Continued declines in home sales show that the housing market is under severe pressure. However, this remains only a mild housing recession by historical standards. It is the first major housing downturn in the U.S. since 1991-1992, so it seems more severe than it is and everyone is pushing the panic button, but one has to remember that real housing recession cycles tend to be dramatic, as major recessions have shown declines of more than 50%. It is indeed interesting that in the 2001 recession, the Federal Reserve's sharp interest rate cuts kept the housing market strong and this time around they are playing the waiting and watching game.

Also, remember that the sharp rise in home prices is a worldwide phenomenon, spurred by low interest rates. As I write this India has started to build million dollar homes in various cities and they are sold out even before a single brick has been laid. To most buyers, the price of a home is essentially the monthly payment, and with U.S. mortgage rates at so low in 2002-2003, Americans could buy a lot of home for only a small monthly payment. But as interest rates rose with the Fed tightening, the monthly payments increased, and homeowners who were selling found that prospective new buyers couldn't pay as much. Some homebuyers dropped out as a result and the homeowners who wanted to sell had to reduce the home prices in order to sell.

Trade Deficit is Shrinking

On the trade front, the deficit has been shrinking slowly since its October 2005 peak of $67.1 billion, to $60.0 billion in May and an average of $59.1 billion for the first five months of 2007. The trade deficit has narrowed in response to three major changes: the fall in the dollar, the weaker U.S. economy, and stronger overseas growth.

The weaker dollar is clearly part of the reason for the improvement. The first impact of a weaker dollar on the deficit comes from higher import and lower export prices, which tend to worsen the deficit in the short term. Only in the longer run do higher export and lower import volumes offset this price effect. The second major change contributing to a smaller trade gap has been the softening of the U.S. economy. As growth slowed to 2% from 3%, demand for imports cooled as well. The third factor is the continued improvement in the world economy, particularly in Asia, Japan and Europe. In 2005, the Eurozone's GDP rose a meager 1.6%; this year, its going to be almost 3%. Similarly, Japanese growth was 1.9% in 2005, and it is 2.3% this year and Asia’s well, I don’t have have to say (considering China and India have been continually posting double digit growth numbers). These figures are especially important because the U.S. exports mostly to the industrial countries, while it imports from non-Japan Asia and the Americas.

Federal Deficit has Fallen

The decline in the federal deficit has been a major surprise to one and all. The gap is expected to be $179 billion in fiscal 2007 (down from $428 billion in fiscal 2002), which is only 1.6% of the U.S. GDP. Strong revenues—not less spending—have narrowed the deficit because government spending rose faster than GDP over the past four years. Spending may slow if there is a decline is military spending (The generals are planning a troop reduction in Iraq as I write this). However, the budget deficit should remain near its current level for the next few years.

State and local governments are healthy, again largely because of strong revenue growth. The aggregate of all state and local budgets have moved back into surplus on an operating basis.

Economy and Inflation

The inflation rate is running at a relatively moderate level. The Fed's preferred measure—the consumer expenditures price index excluding food and energy items—was up only 1.9% from a year earlier in June, which is definitely within the Fed's comfort zone. The Fed remains nervous about inflation (well, they better be as I don’t want to pay 10 bucks for a gallon of milk). One worry, however, is that the downward revision to real GDP growth in the most recent data implies that productivity growth has been running about 0.25 percentage points lower than previous projections, which would reduce the estimated trend growth for the economy to about 3% from the 3.25%. This would also unfortunately revise costs higher, suggesting more inflationary pressure.

The spread between U.S. and European bond yields has narrowed too much and seems too low to attract the funds needed to finance the U.S. trade gap. So I think we can safely say that our German and British friends are not going to be buying US bonds anytime soon. The 10-year U.S. Treasury note is yielding only 0.46 percentage points more than the equivalent Euro bonds, which is less than half of last year's spread. U.S. yields are likely to rise in response to the higher European yields, even if the Fed begins to cut short-term rates early next year.

The economic expansion has slowed, which should not be a surprise after 17 consecutive Fed rate hikes. The growth remains solidly positive, resembling the 1995-1996 period, when real GDP fell back to 2% for a year and then reaccelerated. So far, the slowdown is mostly confined to the housing market, with the consumer continuing to spend confidently. However, the risk remains that higher oil prices or a sharper rise in bond yields, which could in turn further damage the housing market, might still turn lower growth into a recession.

The Stock Market

So the global markets have been falling for the last one week (falling steeply at that). So what is happening to the stock markets?? Is there reason to panic? Well, in 2 simple words: ‘Market Correction’. So much EZ credit was created that people invested like there was no tomorrow and drove up the stock prices to insane levels and

market correct had to happen at some point. Thanks to private equity, billions have been poured into the markets artificially inflating securities. And now with the credit cycle tightening and hedge funds reporting losses, people are starting to pull back. One must remember that all this selling is purely driven by technical factors at this point, because the fundamentals of the market are good. Once a person panics, I doubt if he will be think about the beta of the stock or the EPS or growth potential. But in a way, it’s a good thing that the markets are correcting as it brings back a lot of sanity without the Fed getting involved.

However, global economic fundamentals are strong with real growth happening in Europe and Asia and they continue/will continue to provide a solid base for financial markets to adjust. The overall US economy and the markets are strong enough to absorb this correction.

Verdict: So What Should The Fed Do?

The considerations for the Fed are changing by the day. The disorder in financial markets has caused both the Fed and the ECB to inject liquidity into the system. Regardless of issues of the economy and inflation, the first priority of a central bank is to maintain orderly financial markets. Without orderly markets, the central bank has no direct or indirect control over the economy in any event.

Except for housing, the economy is still expanding by more than 3% annually. But over the last four quarters, there has no doubt been a drop in construction activity which could be the reason GDP has lowered. In all probability, housing will continue to depress growth into early 2008 (especially as the ARM’s reset going in the 2H 07 and 2008). However, the longer term outlook remains solid, with GDP growth likely to return to near its 3% trend by the second half of next year. The economic data continue to show slower U.S. GDP growth. However, the weakness remains isolated in the housing market.

But with the continuing housing problems and sluggish economic growth, the fed is unlikely to tighten this year. On one hand, inflation is still a concern, and on the other hand, labor markets are still tight. In all probability, the Fed is likely to do nothing in the near term with regards to interest rates; Remember that a rate cut will further weaken the dollar and make the treasuries less attractive to foreign buyers. (I doubt if the US can afford to do that at this point). I do, however, anticipate a cut early next year once all the credit and Subprime issues are out on the table and the picture gets a lot clearer. As of now, no one knows how much exposure the various financial institutions have with regards to Subprime (also esp. since it is believed there is a lot of exposure to hedge funds, which are not required to report anything) and additionally the methods to value these securities have come into question (No one is sure what the exact ‘Mark to Market’ values of these securities actually are).

Once the rates are cut, people will start to get more credit and housing will improve, everyone will start buying stocks; people will forget their worries and a whole new economic cycle will begin.

What is Islamic Finance?

After more than three decades of modern Islamic finance and banking , the world is seeing double-digit growth rates for Sharia-compliant assets. Islamic finance and Banking is currently being expanded beyond its historical borders of the Gulf region, where it began to emerge domestically in the 1970s as a result of the oil boom. This has driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world. It has finally emerged in many parts of the world as an alternative financing concept to the conventional orthodoxy of paying interest on borrowings and deposits.

An investing approach based on "Sharia" or Islamic law, Islamic finance has begun to spread all over the world. Modern Islamic financing techniques were developed in Muslim parts of Asia, notably Malaysia, but the boom since the mid-1990s has come from the large oil revenues flowing into the Gulf region. Now, the ideas and concepts of Islamic finance are attracting conventional issuers and investors seeking to tap into new investment opportunities.

What are the key principles of Islamic finance?
To be considered Sharia-compliant, a financial institution or transaction needs to meet the Koran's strict tenets against usury and uncertainty. The most important principle of Islamic finance is "riba," the ban on charging or paying interest. Sharia (set of guidelines as per the Quaran) doesn't consider money as an asset class because it is not tangible; therefore, it may not earn a return. Instead, Islamic law calls for a means of sharing the profits from a transaction or institution among participants - here, the client and financial institution or instrument. Secondly, Islamic law prohibits uncertainty of payout or gambling, but not risk as long as it is shared among all parties. No one participant should shoulder an unequal degree of risk. Thirdly, any Sharia-compliant transaction must be backed by a tangible and identifiable asset. Lastly, Islamic finance forbids investment in or dealings with those industries banned under the Koran: notably alcohol and brewing, tobacco, weapons and armaments, or pork-based products.

How are Islamic banks different from conventional banks?
The biggest difference between Islamic and conventional banks is that Sharia-compliant institutions do not pay interest on deposit accounts. The attraction for clients, however, is that Islamic banks usually also offer profit-sharing investment accounts (PSIAs) that are bound by a "mudaraba" contract. These PSIAs are a major source of funding for Islamic banks.

The Rising Rupee: Boon or Bane?

Rising Rupee

The rupee has been rising against the dollar for the last couple of months. But what has sent the alarm bells ringing is the speed with which the currency has risen (nearly 10% against the $$ in the last 6 months). Though everyone keeps talking only about the dollar, it is interesting to note that the Rupee has, in fact, also steadily risen against other currencies in the last 5-6 months (8% against the pound, 7% against the Euro and 11% against the yen).

Is this a problem or is this really good for the Indian economy?? One thing is for sure. This is a drastic departure from past policies and a strong rupee will have a really big impact on the Indian economy. The main reason for rupee's appreciation in the last 6 months has been the flood of foreign investments and remittances into India (esp. US$). These $ inflows are coming in the form of foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slow down anytime soon. That coupled with the Indian stock market's stellar performance has the foreign portfolio inflows booming. The large and steadily increasing net inflow of foreign exchange into India has translated into an excess demand for rupees. Like any other good or service, the excess demand for rupees has resulted in an increase in the price of the rupee.

The rupee's appreciation is alarming exporters, as it makes their products more expensive in overseas markets and erodes their international competitiveness. The software exporters for one are already starting to miss their earnings. The last month has seen all major software exporters taking a hit and there is already evidence in India of an export downturn in a number of other sub-sectors as well (Textiles and Commodities). This is mainly because Indian exporters earn their revenues in foreign exchange. So the more and more the rupee appreciates, the less and less they earn. The current situation has all the exporters screaming as the profit margins are being squeezed out. In a way this is like the shortest growth story as just when the Indian export industry is being talked about as a great economic engine, it looks like the exporters are already being forced to shut shop as they are unable to compete and losing out to their biggest rival, China.

An important factor in the central bank's policy change in allowing a stronger rupee is the rising inflation. The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. In order to prevent the rupee’s rise, RBI bought close to $20 billion in the last four months to curb the rupee’s rise (Incidentally, India's foreign exchange reserves have now crossed the $200-billion mark). But as RBI purchased dollars (creating more demand for dollar) and sold rupees (increasing supply of INR, thereby decreasing its value), the money supply increased - which meant too much money chasing the same (or less) number of goods – and this led to increased inflation in the country. The increased liquidity therefore fuelled inflation and of course as we all know this comes with a 'Political Cost' attached to it. So the RBI backed off and let the rupee appreciate again. When RBI was buying billions of $$, inflation shot up in excess of 6%, but when they stopped buying $$$, the resulting large drop in money and credit growth lowered inflation significantly - The govt. has targeted a 5% inflation for 2007.

Of course on the flip side, all the importers are extremely happy as imports have become much more affordable. An appreciation of the rupee has made the import of foreign goods (such as crude oil and petroleum products) cheaper (in rupees) in India. The rupee appreciation should exert a downward pressure on the inflation rate. A strong rupee in nearly a decade may be good news for importers and those who see the currency as a symbol of economic prowess. However this does little to prevent the dilution of our country's competitiveness because a cheaper dollar makes imports easier and exports tougher. The profitability of exports is already being affected, and if the appreciation in the rupee continues unabated, they will feel the pinch and exports will suffer.

So is a strong rupee really curbing inflation?? Should RBI buy more $$ to curb the Rupee?? RBI has a difficult policy choice at hand. In which direction it will move will depend on which objective is given more important i.e inflation control, maintaining export growth or capital account convertibility. The government and RBI are keeping their fingers crossed and hoping that there will be no need for a major intervention. However, given the amount of $$ flowing into India the problem is unlikely to disappear soon.

Death Bonds: Praying for people to Die

Move over Hedge Funds...Here comes the Death Bond!!!

Just when you thought you had seen the most analytical, complex, high-risk alternative investment vehicles from Wall Street, they have yet again come up with a new way to make money. Its called the 'Death Bond' and believe it or not, it involves making money when people die. Mmmm.. I thought something was fishy when I heard that Germany unveiled a 24 hour death channel.

How does a Death Bond work?

Death Bonds (or life settlement-backed security) is created in the following way:

1. A person who wants to cash out of a life insurance policy hires a "life settlement" broker to find prospective buyers to sell his insurance policy.
2. The broker seeks bids from specialty finance firms called life settlement providers, which are often financed by hedge funds and investment banks.
3. The life settlement provider resells the insurance policy to a hedge fund or investment bank, which warehouses it in order to build a big pool of policies.
4. After an investment bank/hedge fund collects a sufficient number of policies (around 200-250), it turns them into asset-backed securities called death bonds to sells them to investors.
5. The The buyers keep paying the premiums until the seller dies, and then they collect. The up-front payout to the seller varies widely, from 20% of the death benefit to 40%.

The mechanics in theory seem quite straightforward: Asset Classes are pooled together and then sold off in the form of bonds or pieces of bonds. When people die, the banks collect. When people die quicker, investors get richer. It is estimated that there are 90 million people in the US with Insurance and this is certainly a temptation for Wall Street. Another big attraction for these types of "Asset Classes" are that they are uncorrelated assets (i.e. they aren't correlated with stocks, bonds, commodities, or other investments) and they are also immune to market risks (interest rates, currency risks etc.) which make the portfolios less volatile.

Well the truth is, at this early stage, there's no way of knowing how popular death bonds might become. I for one do not want anyone profiting from my death. But hey, that does not stop me from watching EoS TV.