How US banks created the credit bubble

Apart from the tiny fraction of the US population that understands economics, everyone was content while the private-sector credit bubble was inflating. The Fed chairman was hailed as a "maestro" for keeping interest rates at artificially low levels and thus ensuring that the prices of most investments -- especially high-risk investments -- remained on upward paths, while politicians of all stripes were happy that the market for home mortgages was the greatest 'beneficiary' of the Fed-sponsored inflation of money and credit.

Actually, politicians didn't leave much to chance, in that regulations were passed to encourage the provision of mortgage-related credit to anyone with a pulse and government-sponsored enterprises (Fannie Mae, etc.) worked tenaciously to increase both the supply of and the demand for mortgages.

The banking industry played its part to the hilt by inventing new ways to expand credit (think: Residential Mortgage-Backed Securities and Collateralised Debt Obligations), but it is important to understand that the banks would not have had an incentive to create these new credit-related products unless there existed huge demand for such products. The demand came from large investors -- hedge, bond and pension funds, for example -- that were desperately searching for yield in a world where yields had been kept artificially low by various central bank and government manipulations.

The main problem with credit bubbles is that they result in a massive transfer of resources to activities that would not be economically viable in the absence of the artificially low interest rates and the monetary inflation. Consequently, although they temporarily create the feeling of prosperity, they deplete real savings and lessen the economy's long-term growth potential.

The recession or depression that inevitably follows the bursting of a credit bubble is caused by the ill-conceived investments made during the bubble rather than by the bursting of the bubble itself. Think of it this way: once the bubble bursts and the supply of new credit is curtailed, a light is suddenly shone upon the terrible mistakes that were made during the bubble.

During the giant credit bubble that ended in 2007, the banking industry made more than its fair share of investing errors and was thus eventually left with enormous holes in its collective balance sheet. Some of the largest US banks should have gone under, which would have resulted in the holders of bank equity losing all of their money and the holders of bank bonds losing most of their money.

It would NOT, however, have resulted in bank depositors losing any of their money or in the cessation of the traditional banking businesses (the taking of deposits and the making of loans). Unfortunately, the government deemed that the banks were "too big to fail", and arranged for hundreds of billions of dollars to be siphoned from the rest of the economy to prevent the large banks from collapsing. Note that the banks were not actually "too big to fail". They should have failed, and the US economy would be in far better shape today if they had.

Further to the above, the banks certainly played a role in creating the current mess, but it was a supporting role. The lead roles were played by the government and the Fed. However, now we have the ridiculous situation of US policy-makers passing legislation that grants themselves greater power and crimps the activities of the banks, with the stated aims of mitigating the risk of another financial crisis and preventing banks from becoming "too big to fail". If they are serious about mitigating the risk of another financial crisis then they should pass legislation that abolishes the Fed and severely crimps the activities of the government.

The attacks on the banks are nothing if not predictable. Throughout history the ends of giant credit bubbles have invariably been followed by periods of recrimination, when politicians looked around for someone other than themselves to blame. In the current case the banking industry is the most logical target because it is blatantly obvious that the large banks have profited handsomely at the expense of taxpayers over the past 18 months. But isn't it bizarre that the finger of blame is being self-righteously pointed at the banks by the very same people who arranged or approved the gargantuan wealth transfer from taxpayers to banks?

Fifty years on: Gujarat PSEs yield gold for investors

The day marks the golden jubilee year of the formation of the state of Gujarat, which was separated from the erstwhile state of Bombay Presidency on the 1st May 1960. Ever since its formation as a separate state, Gujarat has been thriving to be on the forefront of numerous socio-economic platforms, then let it be agriculture, industries, services or civil society. Gujarat has successfully marked its significance not only domestically but internationally too.

Tracking the golden jubilee celebrations of the 50 glorious years of its existence, Gujarat has emerged as the only state in India to have some of the large public sector enterprises listed on the bourses and yielding heavy returns for the investors. As many as six state PSEs are on the public listings and have witnessed significant appreciation of the stock prices over the years.

The six PSEs, namely Gujarat Mineral Development Corporation (BOM:532181) (GMDC), Gujarat State Petronet Ltd (BOM:532702) (GSPL), Gujarat State Fertilizers & Chemicals Ltd (BOM:500690) (GSFC), Gujarat Alkalies & Chemicals Ltd (BOM:530001) (GACL), Gujarat Narmada Valley Fertilizers Company (BOM:500670) (GNFC) and Gujarat Industries Power Company Ltd (BOM:517300) (GIPCL) have emerged as the Navratna companies for the state and the investors.

GMDC, a mining major operates in two segments, mining and power. The company produces lignite, bauxite, calcined bauxite, fluorspar and manganese ore. GMDC is one of the prominent mining and mineral processing companies in India. The company stocks have appreciated by 159.5% in past one year from Rs.54.50 to Rs.137 in the recent trades on the Bombay Stock Exchange (BSE). Meanwhile, the benchmark index, Sensex has surged by 98.5% over past one year to the current level of 17,558 points.

GMDC has been consistently giving dividends to the investors over the years. The company has posted a net profit of Rs.71.19 crore for the quarter ended December 31, 2009 as compared to Rs.74.71 crore for the quarter ended December 31, 2007. Total Income has increased from Rs.262.88 crore for the quarter ended December 31, 2008 to Rs.282.03 crore for the quarter ended December 31, 2009.

Gujarat’s largest caustic chlorine maker, GACL made a history in the state’s chemical sector when the company joined hands with European chemical major, Dow Europe GmbH for setting up an environment-friendly chloromethane plant at Dahej with an investment of Rs.600 crore. The project is underway and expected to be commissioned in early 2011.

In past one year, GACL stocks have gained 57% from Rs.82.70 in the early May 2009 to Rs.117.20 in the latest trades on BSE. The company has a market capitalization of Rs.8.61 billion as on Friday, April 30, 2010.

GSPL, is a pioneer in developing energy transportation infrastructure and connecting natural gas supply basins and LNG terminals to growing markets. The company stocks have yielded robust returns for the investors as the stock price has appreciated by over 138% YoY to Rs.95.30 in recent trades on BSE.

GSPL is a future hope for the industrial growth in Gujarat as the company is developing some of the key industrial infrastructure projects like gas grid development. The company has commissioned various pipeline projects across the state.
Gujarat is once again at an advantage as the state has one of the world’s largest single-stream ammonia-urea fertilizer complexes at GNFC. The company has developed much beyond plant food through a process of horizontal integration. Chemicals/petrochemicals, energy have already been added to the company’s kitty.

GNFC stocks have appreciated by 78.66% over past one year to the current level of Rs.120.15, giving heavy returns to the investors in the long run. The company has the market capitalization of Rs.18.67 billion as on 30th April, 2010.

Another fertilizer and chemicals major, GSFC has been leading fertilizers provider to the agriculture in India. The fertilizer products include urea, ammonium sulphate, di-ammonium phosphate, ammonium phosphate sulphate and traded fertilizer products. GSFC also manufactures some of the speciality chemicals for the industrial purposes, that include caprolactam, nylon-6, nylon filament yarn, nylon chips, melamine and polymer products. Initially, with the equity structure, comprising of 49% of State Government participation and 51% of Public and Financial Institutions, today the Government’s involvement has come down to 38.4%.

The company stock prices have swollen to Rs.259.90 on 30th April 2010 rising 131% over past one year with company’s market capitalization soaring to Rs.20.71 billion.

In order to attain self sufficiency in power generation to provide good quality and uninterrupted power to the state industry and agriculture, Gujarat, over past several years, has been emphasizing on developing larger power generation capacities. GIPCL is a step in this direction. The company, however, has the total generation capacity at 5560 MW at its two power plants located in Vadodara and Mangrol.

Presently, two units of 125 MW SLPP phase II expansion project with expansion of lignite mines is underway and the project is expected to be commissioned in the current fiscal. The state government has consented to allot 500 MW expansion Phase-III to GIPCL. The site selection, environmental clearances and other formalities are in the advance state of progress.
The company stocks gained by 97% over past one year leading the company’s total market capitalization to Rs.17.92 billion as on 30th April 2010. The company stocks ended the last trading session at Rs.118.50 on BSE.

Looking at the robust performance by the state PSEs has proved that despite being public sector enterprises, the companies have flared well in comparison to other PSUs in the country. Surprisingly, no other state has achieved such significant milestone in the field of industrial development.

Gold sale profit to hit $5.1 billion : IMF

The IMF said Sunday it expects to record a profit of $ 5.1 billion from the sale of gold in the financial year ended April 30, 2010.

In a statement, the International Monetary Fund, which sold gold to member countries including India last year, said gold sales is a part of the multilateral lending agency’s new income model, mainly aimed at increasing its resources to lend to low-income countries.

The net income in the 2010 financial year (ended April 30) would include “gold profits estimated at about SDR 3.5 billion ($ 5.1 billion) from part of the limited sale of the fund’s gold,” according to the IMF.

SDR or Special Drawing Rights is an international reserve asset created by the IMF to supplement its member countries’ official reserves. The value of SDR is based on a basket of four key international currencies -- the euro, Japanese yen, pound sterling and US dollar.

In its mid-year review, the IMF had estimated that its profits from gold sales would be worth about SDR 3.25 billion.

This projection has now been raised to SDR 3.5 billion.

The IMF sold 212 metric tons of gold in October-November, 2009. Out of the total, India purchased 200 tonnes at an estimated cost of $ 6.7 billion.

“The gold sales, a central element of the fund’s new income model, will fund an endowment and also increase the fund’s resources for lending to low-income countries...,” the agency said in a recent statement.

Meanwhile, the IMF is expected to report a net operational income of SDR 365 million (about $ 534 million) for financial year 2010, compared to earlier estimates that pegged net operational income at SDR 290 million (about $ 424 million) at the beginning of the year.

“This improved outlook is primarily attributed to higher than expected earnings on the fund’s investment portfolio, which is made up largely of fixed-income securities, and lower net administrative expenditures, in SDR terms, reflecting movements in the US dollar/SDR exchange rate,” the statement noted.

Investment strategies for uncertain times

A situation where earnings growth is rising and projected to continue rising, while share prices are falling, is unusual.

We can see it happening now, and it could continue, given the panic in Europe.

Normally, one would expect long-term investors to be happy at the chance to invest in profitable businesses at lower prices.

But, little about the current situation is normal.

The last time there was a crisis of these dimensions in 2008, it triggered a 15-month bear market that knocked more than 50 per cent off index values.

What is the real benefit?

More pertinently, it retarded Indian GDP growth by at least 1.5 per cent and had an adverse effect on earnings over a two-year period.

Several things may go wrong with the current projections for India if the European situation gets worse.

Indian exports, which are still depressed, could spend a further indefinite period in the doldrums.

Second, Indian businesses looking to tap overseas finance (notably real estate and telecom) will run into reluctance.

Third, domestic consumer spending itself could drop if white-collar increments are frozen.

Lastly, there might be an absolute hard-currency collapse and that would have consequences that are impossible to assess.

So, should Indian investors be buying under the circumstances?

For regular returns

On balance, I'd say yes.

The absolute currency collapse is not very likely to happen and, under other circumstances, the Indian economy will continue to recover gradually, if not at the rates that were optimistically projected before the Greek tragedy.

But, any buying should be very cautious and done in staggered fashion.

Here are some possible sign posts.

Prices could drop or remain depressed for several months.

Hence, slow systematic buying strategies will yield better returns by lowering average price of acquisitions.

Above all, don't commit funds that you'll need to touch for several years. If the index is down another 20 per cent, a year down the line, you want to be able to reduce your average cost of acquisition rather than be forced to sell out to cover other expenses.

Declare the correct investment details

Second, avoid companies that are heavily dependent on exports or on debt infusions.

In the first case, the reasons are obvious - export growth will be slow or negative. Debt will also be very hard to come by and expensive as well. Expansion plans everywhere are likely to go on hold.

Third, look for attractive valuations with regards to the current balance sheet, rather than strong growth prospects.

A low-debt company that is available cheap (in terms of a low current PE, PBV, etc) is less likely to suffer dramatic erosion in valuations.

Fourth, don't expect further stimulus packages from the Government of India - it doesn't have the resources.

Uncertainty in equities, bull phase soon

Global financial markets continue to be driven largely by the sovereign debt issues facing Greece and other European countries but uncertainty clouds the market even as a bull trend is likely soon, according to Bob Doll, Vice Chairman and Chief Equity Strategist for Fundamental Equities at BlackRock, a premier provider of global investment management, risk management and advisory services.

In his weekly commentary, he said that stocks continued to face high levels of volatility last week as a strong rebound in prices early on gave way to renewed weakness by week’s end. Overall, markets did manage to post gains, with the Dow Jones Industrial Average rising 2.3% to 10,620, the S&P 500 Index advancing 2.2% to 1,136 and the Nasdaq Composite gaining 3.6% to end the week at 2,347. Following these gains, stocks moved back into positive territory for the year.

The events in Europe also serve as a reminder that the world appears to be entering a period marked by higher taxes and increased regulation. "In the United States, we expect Congress will act at some point to perpetuate the Bush-era tax cuts for those making under $200,000, but will increase tax rates on higher-income earnings and on capital gains and dividends."

From an equity market perspective, the initial relief over the creation of the rescue plan (which drove markets sharply higher on Monday) eventually gave way to skepticism as investors continued to question European governments’ ability to repay their debt. More broadly, investors have grown increasingly concerned about the potential for contagion, fearing the credit issues could affect other markets. At this point, it is difficult to say whether the rescue program will result in a recovery
in confidence levels, but the scope and size of the plans are encouraging, Bob Doll said in his commentary.

The plans do not address the underlying fundamental issues facing Greece and other countries, which will still have some difficult decisions to make in terms of managing their balance sheets. In the short term, however, the immediate liquidity risks should be contained. On balance, it appears investors are awaiting more details and markets still need to be convinced that the plans enacted by the European Central Bank and other policymakers will work.

Looking ahead, there appear to be three possible directions that the European debt crisis could take. The first, and most pessimistic, would be something similar to what happened in late 2008, when the global financial system entered a free fall after the collapse of Lehman Brothers. We think such a scenario is unlikely, as there are several important differences between the credit crisis of 2008 and the events of today. Namely, credit risks involving governments are significantly more transparent
than those surrounding subprime loans and collateralized debt obligations were a couple of years ago; the broader global economy is firmly in recovery mode; inflation levels are low; the banking system as a whole is in better shape; and global policymakers are highly attuned to the downside risks. The second scenario would be a longer-term continuation of a volatile trading range as the competing crosswinds of economic growth and increased liquidity battle against deteriorating credit
conditions and widespread uncertainty. This has been the case for the past several weeks, and this backdrop will continue.

The third scenario would be a victory by the bullish forces that could result in a renewed rally for risk assets. "We do expect to see this result at some point—such was the case after the January/ February downturn. The fundamental uncertainty surrounding credit issues, however, could make the current trading range persist for longer.

One of the spillover effects of the European sovereign debt crisis has been the appreciation of the US dollar versus the euro. The rising dollar has been a source of concern for some investors, since a stronger dollar could have negative implications for US corporate profits. While the trade-weighted value of the dollar is still below its average level of the past several years, the weaker euro could present a risk for US stocks, as could weaker levels of European economic growth.

Another question prompted by the current crisis is what impact all of this will have on the Federal Reserve’s decisions regarding US interest rates. "We had expected that, with the resumption of jobs growth, the Fed would soon signal that it was nearing a change in its forecast, paving the way for an increase in interest rates by the end of the year. That forecast is now looking more uncertain, implying that the Fed is likely to keep rates on hold for a bit longer. An extended period of excess global
liquidity should provide a tailwind for stocks, commodities and other risk assets," Bob Doll said in his commentary.

"On a relative basis, US markets have benefited from the uncertainty, as investors have continued to view the United States as a higher-quality haven for their assets. We expect that this trend will continue, which makes US stocks more attractive than those of other developed markets."